Opportunity Zones vs. 1031 Exchanges for Capital Gains Tax Deferral

Opportunity Zones and 1031 Exchanges Compared

Opportunity Zones offer an incredible opportunity for eligible investors to defer their capital gains until 2027. They also permit investors to avoid any capital gains on any appreciation in their Opportunity Fund investment, given that it’s held at least 10 years. For these reasons, investing in Opportunity Funds is often compared to another capital gains tax deferral mechanism, the 1031 exchange. While 1031 exchanges have many similarities to Opportunity Fund investments, they also have quite a few major differences.

1031 Exchanges Are Limited to Real Estate, While Opportunity Funds Are Not

1031 exchanges are expressly for “real property”, and exclude residential homes, which, in practice, means they can only be used to defer taxes on commercial real estate. In addition, 1031 exchanges are “like-kind” exchanges, which means, according to the IRS, that the property must be of “the same nature, character or class.” The IRS mentions also mentions that “quality or grade does not matter.”

While this may sound extremely strict, it’s not quite as limiting in practice as IRS rules could make it seem. In fact, it’s not unheard of for retail commercial property to be exchanged for an office building or even an industrial warehouse. However, investors attempting a 1031 exchange should always make sure to consult with experts, as, if they unknowingly exchange “non-like-kind” property, they could be stuck with a large tax bill.

In contrast, Opportunity Funds can invest in both businesses and property. However, to invest in a property, it must be located in one of the 8,700 census tracts designated as Qualified Opportunity Zones (QOZs). However, in order to achieve the tax benefits, the Opportunity Fund needs to either construct a new building, or invest more in rehabilitating a building than they did to purchase the property in a first place. To invest in a business, it must be located in a QOZ, and must do 50% or more of its business inside the Opportunity Zone. In addition, no “sin” businesses are permitted to be part of Opportunity Fund investments. Prohibited business types include massage parlors, saunas, golf courses, hot tub facilities, tanning salons, racetracks or gambling facilites, or stores which sell beer or liquor ‘to-go’ as their primary business.

Tax Benefits of 1031 Exchanges vs. Opportunity Funds

The 1031 exchange allows the investor to defer taxes until they sell the exchanged property— which they could also later exchange for another property in a second 1031 exchange. In fact, as long as an investor kept exchanging properties, they could theoretically avoid paying capital gains taxes indefinitely. However, when they do eventually sell their property, they will need to pay the full capital gains tax, including any capital gains that new property has made.

In contrast, if you invest in a Qualified Opportunity Fund, you will only be able to defer your initial capital gains taxes until April 2027. However, if you keep your investment for at least 5 years, you will receive a 10% discount on your deferred capital gains taxes, and if you keep your investment in the fund for at least 7 years, you will receive an additional 5% discount, bringing your total discount to 15%. In addition, if you keep your investment in an Opportunity Fund for at least 10 years, you will not have to pay any capital gains taxes on any appreciation your investment has made since you placed your money in the fund. Investors can keep money in Opportunity Funds until 2047, meaning that they can enjoy nearly 30 years of essentially tax-free gains.

Opportunity Zones Are Time Sensitive, 1031 Exchanges Are Not

The 1031 exchange has been used sine 1921, and is unlikely to be going anywhere soon. However, the same cannot be said about the Opportunity Zones program. In fact, individuals are groups who wish to defer their capital gains on an investment must act quickly, as capital gains can only be deferred until April 2027. In order to take advantage of the full tax 15% capital gains tax exclusion, an investment will need to have been in the Opportunity Fund for 7 years by December 31, 2026, while to achieve the 10% capital gains tax exclusion, the investment will need to have been in the fund for 5 years by that same date.

However, even if they do not make use of these initial capital gains tax benefits by investing after the deadline, investors can still profit from Opportunity Funds, since, as we just mentioned, they will not have to pay any capital gains taxes on the new appreciation of their investment once it has entered the fund.

1031 Exchanges Are Still Superior For Certain Investors

While the Opportunity Zones program offers a much greater potential for tax benefits than the 1031 exchange, it isn’t right for everyone. If you’re an investor who already owns significant commercial property, and wants to exchange one property for a similar property (especially for a property located in a top MSAs or another high or medium income areas) the Opportunity Zones program will not fit your needs.

Likewise, if you want to defer paying your capital gains taxes further out than April 2027, investing in an Opportunity Fund may not be a good choice. Finally, it’s also important to realize that Opportunity Funds strictly limit people investing in funds who are financially affiliated with the fund itself (ex. a company selling commercial real estate to an Opportunity Fund in exchange for a a certain number of shares). Generally, such affiliated entities can own no more than 20% of the shares of Opportunity Fund. In comparison, 1031 exchanges have no such rules, and funds can easily be exchanged by related parties.