Opportunity Zones versus 1031 Exchanges

Opportunity Zones versus 1031's: An advanced lesson
by Dena Landon, posted in Investment Strategy

One of the best ways to generate revenue that leads to financial independence is to invest in real estate. It’s why you’re reading this article right?

If done correctly, real estate investment offers a generous upside, but those gains often come with a hefty tax bill.

Capital gains tax is a tax on the profit made selling a non-inventory asset such as a building, stocks, bonds, or precious metals. This tax can eat away at your profit if you don’t play it smart. To defer or eliminate capital gains tax, smart investors structure their deals to take advantage of two ways to limit their tax burdens; opportunity zone funds and 1031 exchanges.

Real estate investors should learn the ins and outs of both options and how they could impact their investing strategy.

What is an opportunity zone?

The government established opportunity zones as part of the Jobs Act in 2017, adding them to the tax code to incentivize long-term investments in low-income urban and rural communities. An opportunity zone’s investment rolls over capital gains and helps a real estate investor to both earn more and keep more of their gains. Investors don’t buy properties directly in an opportunity zone; instead, they buy into an opportunity zone fund.

Tax benefits of opportunity zones

A qualified opportunity fund or QOF can protect your gains by offering three primary tax benefits to investors.

Reduce tax burdens

It allows investors to reduce tax accountability by 10% if investing for more than five years. It will reduce your tax burden to 5% if invested in opportunity zones for around seven years. After nine years, the tax liability on capital gains will be eliminated.

Defer capital gains taxes

To take advantage of the tax benefits, you only have to invest the capital gains you made on a previous investment within 180 days, not all the money you made from that transaction. These gains can come from investing activities outside of the opportunity zone. When invested in an opportunity fund, you defer paying taxes on those capital gains.

Eliminate capital gains taxes

Investors who have invested in opportunity zones for more than ten years will be exempt from paying any capital gain tax. It’s the best deal for real estate owners who don’t want to pay capital gains, but it does have some downsides.

The downside of investing in opportunity zones

Do your research before deciding to invest in opportunity zone funds. You will be investing in a low-income neighborhood, which could mean higher crime rates, less-qualified tenants, and higher risk. There is a reason that the government felt they needed to incentivize investment in these qualified opportunity zones.

To take the most advantage of the tax breaks offered by an opportunity zone investment, you’ll have to leave your capital invested for up to ten years. It’s a long-term strategy, and won’t work for investors who prefer to keep their capital liquid.

The best way to protect your investment and ensure growth is by opting for opportunity zones that have created a safe territory for investors and where investment has already started to impact the area positively.

1031 Exchange rules

1031 exchange rules offer similar benefits as opportunity zones; either capital gains tax deferral or elimination. A 1031 has a different framework than opportunity zones but gives you a similar outcome.

In a 1031 exchange, you must buy and sell properties within a short timeframe, but where you can invest isn’t limited geographically. These are called like-kind exchanges, where you’re exchanging one asset for another that is just “like” it.

Types of 1031 exchanges

There are five major types of 1031 plans that investors can utilize.

  • Delayed Exchange: After an investor sells one property, there is a slight delay before they reinvest the capital gains into purchasing another property. Fund are held in escrow until closing.
  • Simultaneous exchange: Investors simultaneously replace the property sold along with the new investment.
  • Delayed reverse exchange: With this type of exchange, an investor buys the new property before selling or relinquishing the current property.
  • Built-to-suit exchange: A type of 1031 that enables investors to replace their current building with one built to meet their specifications.
  • Delayed/Simultaneous built-to-suit exchange: The“built-to-suit” property is built before the current property is sold.

User-friendly rules of 1031 exchange

Taking advantage of the tax deferral benefit of a 1031 exchange requires advance planning. The following are the rules that must be taken into consideration when conducting purchases and sales within a 1031 exchange.

  • Equal/greater than: The replacement property value must be equal to or greater than the property to be sold.
  • Identification: The replacement property must be identified within 45 days.
  • Purchase: The replacement property must be purchased within 180 days.

Opportunity zones versus 1031 exchanges

There are pros and cons to both strategies, which you should consider when deciding between investing through a 1031 exchange or in an opportunity zone.

  • Opportunity zones have an advantage over 1031 exchanges in that they can completely eliminate capital gains tax. In a 1031 exchange, you’re just deferring it.
  • With a 1031 exchange, you can select the next investment and don’t have any geographic limitations. If you’re investing in opportunity zones, you have less control over where your money is going. The fund must invest 90% of its capital within the zone’s geographic area, and you are also trusting that the fund’s managers will choose good investments.
  • When using the 1031 exchange, investors need to invest in the property of at least equal value. However, in opportunity zones, the investor only needs to reinvest capital gains for maximum tax benefit.
  • If you’re investing in an opportunity zone fund for tax purposes, your capital is essentially illiquid. Early withdrawals negate the fund’s benefits.

Some investors will prefer the 100% elimination of capital gains, whereas others won’t like having their reinvestment options limited to one area and their capital deployed by someone else. Whether you choose to put capital gains into a qof or a 1031 exchange will depend upon your risk appetite and investment and tax strategy.