What are Opportunity Zones funds and 1031 exchanges?
Both Opportunity Zone funds and 1031 exchanges are ways of reinvesting gains from the sale of property into other property in order to avoid current taxation and obtain valuable tax benefits. Both regimes were created by Congress and codified in the Internal Revenue Code. Both are important tools for managing tax liabilities and for acquiring tax-advantaged investments. One is driven by a national agenda to promote investments in certain locations; the other is driven solely by the taxpayer’s agenda. One regime is very old; the other is very new. Which is the right one for you? Read on…
“They are almost like kissing cousins because they are in some ways parallel, but there are important differences here,” shared Jim Lang, a shareholder with Greenberg Traurig, who participated in our Opportunity Zones webinar in April.
Investors with a 1031 exchange who reinvest in “like-kind” replacement property defer the tax on the gain from the sale of the existing property, unless and until they sell the replacement property. If the investor decides to once again roll their investment into another eligible, “like-kind property,” the gains continue to be deferred until a property is finally sold in a taxable sale. The Tax Cuts and Jobs Act of 2017 made major changes to Section 1031 by limiting the scope of eligible property to only real property and eliminating entirely the eligibility of personal or intangible property.
The 1031 exchange is a nearly century-old method to defer taxes on capital gains or depreciation recapture, and many investors that use 1031 exchanges “roll theirs forever until the great basis step-up in the sky, and the tax is presumably never paid on those assets…,” explained Lang.
The Opportunity Zones (OZ) program, however, is quite new and was created by Congress as part of the Tax Cuts and Jobs Act of 2017 by adding two new sections to the Internal Revenue Code, Sections 1400Z-1 and 1400Z-2. The purpose of this new program is to encourage long-term investments in low-income communities across the United States. There are over 8,700 Opportunity Zones in the country, including territories such as Puerto Rico, and investors can defer tax on any prior gains properly invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026.
- If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.
- If held for more than 7 years, the exclusion is increased to 15%.
- If the investor holds the investment in the Opportunity Fund for at least 10 years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.
How are Opportunity Zones investments and 1031 exchanges similar? How are they different?
Both OZ investments and 1031 exchanges provide significant federal tax benefits and impose a 180-day limitation on the time taxpayers have to complete the investment. But what makes them different?
According to Jill Hamer, attorney and founder of CRE NET in New York, both the 1031 exchange and Opportunity Zones funds are similar, but the Opportunity Zone funds have a distinct advantage over 1031 exchanges. “Opportunity Zone funds allow the elimination of any capital gains taxes earned from the Opportunity Zone fund investment, under certain conditions,” said Hamer, who recently hosted an Opportunity Zone event at Fordham University School of Law. “So, not only does an Opportunity Zone fund investor have the ability to defer and reduce their initial capital gains tax bill, they also may be able to eliminate the payment of any capital gains taxes certain conditions.”
Hamer wanted to reemphasize an important point that many discussions about Qualified Opportunity Funds skip over. “Keep in mind that the elimination of any subsequent capital gains taxes assumes that the value of the underlying investment in the Opportunity Zone fund increases,” said Hamer. “For this reason, investors should carefully choose an Opportunity Zone fund.”
Greenberg Traurig’s Jim Lang also noted another difference between Opportunity Zones and 1031 exchanges: “When you use an Opportunity Zone fund to invest through, you are just investing your gains dollars. You are not investing your whole investment.” Thus, if the investor has basis in the property sold, then they need only invest the capital gain — the difference between the sales price and basis — in the Opportunity Zone fund in order to get the maximum tax benefits. This provides liquidity for the basis in the property sold and provides cash to the investor.
In contrast, with 1031 exchanges, in order to get the maximum tax benefit, the exchanger must reinvest in property of at least the same value, including the amount of any debt secured by the property. This often requires that the exchanger add in new funds or borrow again, since debt secured by the existing property must usually be paid in full upon its sale.
Aside from the differences in the tax rules and tax benefits, there are several other differences between QOF investments and 1031 exchanges. 1031 exchanges are now limited to real estate, but QOF investments are not. QOF investments require that the investor invest in the Opportunity Zone through the use of a legal entity that is taxed as either a partnership, such as a limited liability company, or a corporation, which in turn invests in an Opportunity Zone business (which itself is either a partnership or corporation), or directly into Qualified Opportunity Zone business property. 1031 exchanges do not require the use of a fund, and they actually prohibit using a corporation or a partnership as a vehicle through which to invest in property. 1031 exchangers can invest in real property anywhere in the United States (if the property sold is domestic property) or internationally (but if the property sold is international property); but QOF investments are limited to the Opportunity Zones. 1031 exchangers file a single IRS Form 8824 for the year of the sale of their property, while QOF managers must report annually through IRS Form 8996.
Contact us with your Opportunity Zones and 1031 questions.
Here at NES Financial, we lead the industry in successful 1031 exchanges each year.
And in the OZ space, our purpose-built Opportunity Fund Administration Solution provides investors optimal visibility into Opportunity Zone Fund performance and investment information through a secure web-based portal, which is accessible 24/7. We track book and tax bases for fund investments, report on new tax basis calculations for 5- and 7-year benefits, and calculate adjusted basis on 12/31/2026 based on years held — so investors can fully enjoy the tax benefits to which they are entitled.
 Internal Revenue Code Section 1400Z-2(b)(1).
 IRC Section 1400Z-2(b)(2)(B)(iii) and (iv).
 IRC Section 1400Z-2(c).
 IRC Sections 1400Z-2(a)(1)(A) and 1031(a)(3)(B).