Opportunity Zones or 1031 Exchanges? Key Differences Explained.
Opportunity Zones (OZS) were developed to spur development and investment into certain distressed communities throughout the US. Investing into qualified opportunity zone funds offer tax advantages that allow investors to save on capital gains taxes once properties are developed then sold.
The similarities and tax benefits of a 1031 exchange and opportunity zone fund allow investors to defer the gain on the sale of an investment or property, this is the main reason 1031 Exchange investment have historically been so popular. These gains from initial investments have typically been reinvested which helps keep money in the real estate market, further encouraging growth. 1031 exchanges and OZS investments into real estate have a low correlation to the wider market, allowing further portfolio diversification and investment risk management.
However, OZS and 1031 exchanges have a few significant differences, including tax treatments and rules around where gains may come from.
One key difference between OZS and 1031 exchanges is how long the gain is deferred, for 1031 exchanges the investor may defer the gain from the sale of the previous property until the sale of the replacement property, if the investor decides to roll their investment into yet another eligible property, gains can be continually deferred until a property is finally sold. For OZS fund, the investor may defer the tax on the gain from the sale of a previous property or dec 21 2026, whichever comes first. As a result, investors in 1031 exchange may be able to defer recognition of their gain for a longer period than investors in OZS if the 1031 property is held after December 21 2026.
Perhaps the largest difference between the tax benefits of participating in a 1031 Exchange and investing in a Qualified Opportunity Fund is the stepped-up basis on the investment into a Qualified Opportunity Fund if the investor holds it for more than 10 years. This means that when the investor sells her investment in the Qualified Opportunity Fund, her basis (the amount of the original investment) is increased to the fair market value at the time of the sale. Since taxpayers are taxed on the difference between their basis and the sale price, this effectively means the transaction will be tax free. In a 1031 Exchange, the original basis follows the investor through the exchange and is used when the replacement property is finally sold, at which time the investor pays the tax on the difference between their basis in the original property and the sale amount of the replacement property. The stepped-up basis for investments into a Qualified Opportunity Fund is a huge benefit for investors who are able to hold an investment for that long.
Another key difference between 1031 exchange and OZS is the types of property into which an investment can be made. For a 1031 exchange, the IRS requires the replacement property to be of "like-kind" to the property the taxpayer sold, this means the property will need to be the same nature, class or character as the original. Also, the property must be used for trade, business or investment, this means commercial real estate is likely a good candidate for 1031 exchange. Opportunity Zone Funds consist of designated distressed communities around the country, thus only property in these zones will qualify.
1031 Exchanges and investments in Qualified Opportunity Zone Funds are both enticing opportunities for savvy investors, but, despite their similarities, the differences between these two investment opportunities require just as much due diligence and research before any potential investment is made. There is a lot of crowding into the OZ space right now and we would recommend talking with a professional about these investments as pricing may be irrational due to the tax benefits.