1031 Exchange vs. Opportunity Zone: A Comparison
A comparison of two capital gain deferral strategies, examining the mechanics of reinvestment, the nature of the tax benefit, and long-term financial implications.
Investors seeking to postpone taxes on investment profits have several avenues to consider. Two prominent strategies are like-kind exchanges, often called 1031 exchanges, and investments in Qualified Opportunity Zones. While both paths offer a way to defer recognizing a gain, they operate under different rules and provide different long-term outcomes regarding eligible gains, investment types, tax treatment, and timelines.
Eligible Gains and Required Investments
A primary distinction between a 1031 exchange and an Opportunity Zone (OZ) investment is the type of gain that qualifies for deferral. The rules for a 1031 exchange, governed by Section 1031 of the tax code, are narrow, applying only to gains from the sale of real property held for productive use in a trade or business or for investment.
Following the Tax Cuts and Jobs Act of 2017, like-kind exchanges were restricted solely to real estate, meaning personal and intangible property no longer qualify. The proceeds from the sale of the qualifying real estate must be reinvested into another real property that is considered “like-kind.”
The definition of “like-kind” for real estate is interpreted broadly by the IRS. For example, an investor can exchange an apartment building for raw land or a retail center for a single-family rental. Both the relinquished and replacement properties must be of the same nature or character, even if they differ in grade or quality.
Opportunity Zone investments provide a much wider net for eligible gains. An investor can defer a gain from the sale or exchange of nearly any capital asset, including profits from selling stocks, bonds, a privately held business, cryptocurrency, or real estate.
The reinvestment requirement for an OZ investment is also different. An investor must place the eligible capital gain into a Qualified Opportunity Fund (QOF), which is a specialized investment vehicle created to invest in OZ property. The QOF then uses its capital to acquire property located within a designated Opportunity Zone, which often must be substantially improved by the fund.
Tax Treatment of Deferred Gains
The tax outcomes for deferred gains under a 1031 exchange and an Opportunity Zone investment differ significantly. A 1031 exchange provides a tax deferral, not forgiveness, meaning the capital gains tax that would have been due is postponed.
This deferral is achieved through a carryover basis. The tax basis of the original property, its cost minus any depreciation, rolls over to become the basis of the new replacement property. This preserves the deferred gain within the new investment, which will be subject to tax upon its eventual sale.
Investors can conduct a series of 1031 exchanges, continuously deferring the gain from one property to the next. The tax liability on these accumulated gains can be eliminated if the investor holds the final property until death. At that point, the property’s basis is “stepped up” to its fair market value for the owner’s heirs, which eliminates the deferred capital gain for federal income tax purposes.
For an Opportunity Zone investment, the tax on the original capital gain invested into a Qualified Opportunity Fund (QOF) is deferred. This deferral is temporary, ending when the OZ investment is sold or on December 31, 2026, whichever comes first. The main tax advantage relates to the new investment in the QOF. If an investor holds their interest in the fund for at least 10 years, any appreciation on that investment can be free of federal capital gains tax upon its sale.
Investment Timelines and Location Rules
The rules for investment timing and geography contrast sharply between the two strategies. For a 1031 exchange, an investor faces two deadlines that begin when the original property sale closes. There is a 45-day period to formally identify potential replacement properties in writing.
After the identification period, the investor has a total of 180 days from the original sale date to purchase one of the identified properties. These two periods run concurrently; if an investor identifies a property on day 45, they have 135 days left to close. The replacement property can be located anywhere within the United States.
For an Opportunity Zone investment, an investor has 180 days from the date of the sale that generated the capital gain to reinvest those proceeds into a Qualified Opportunity Fund.
Unlike the geographic freedom of a 1031 exchange, OZ investments are constrained. The program is designed to spur economic development in specific communities. A QOF must invest its assets in property or businesses located within a federally designated Opportunity Zone, which are specific census tracts certified by the U.S. Treasury Department.