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1031 Exchange
Qualified Opportunity Zones (QOZ)

1031 Exchange vs. Qualified Opportunity Zones: Which Is Better?

Daniel Goodwin on Apr 23, 2022
1031 Exchange vs. Qualified Opportunity Zones - Provident 1031 Houston
Table of Contents
  1. 1031 Exchange vs. Qualified Opportunity Zones
    • Instant & Long-Term Tax Advantages
  2. Which Is The Best, A 1031 Tax Exchange or A QOZ Real Estate Investment?
  3. What Are Qualified Opportunity Zones?
  4. What Is A 1031 Exchange?
  5. Key Advantages of A Qualified Opportunity Zone
  6. Key Advantages of A 1031 Exchange
    • Tax Deferral
    • Swap or Consolidate Properties
  7. QOZ or 1031: Which Investment Is for Me?
    • Defer Taxes
      • Advantage:
    • Realize Profits
      • Advantage:
    • Estate Planning Tool
      • Advantage:
  8. Key Takeaways

1031 Exchange vs. Qualified Opportunity Zones

Instant & Long-Term Tax Advantages

Today investors can structure real estate investments to generate instant tax benefits and long-term tax advantages.

For decades, savvy real estate investors have used Section 1031 exchanges to trade real estate assets without incurring taxable gains. However, the relatively new Qualified Opportunity Zone program also provides options for deferring taxes and, in some cases eliminating taxable profits, prompting many real estate investors to ask this question:

Which Is The Best, A 1031 Tax Exchange or A QOZ Real Estate Investment?

The IRS has established tight regulations for both alternatives, and some real estate investments may qualify for both tax benefits.

However, before determining which approach to take, real estate investors must understand the distinctions between the two and how they impact their taxable gains.

What Are Qualified Opportunity Zones?

Economically distressed communities that need investment and revitalization are referred to as opportunity zones, however many properties within opportunity zones have gone through major transitions and are ripe for development.

The goal of opportunity zones, established by the Tax Cuts and Jobs Act of 2017, is to encourage economic growth and job creation by offering tax incentives for investing in community developments in these areas.

Opportunity Zones can range from rural areas that lack services, to blighted neighborhoods, to prime areas for development that have already experienced economic redevelopment.

State governors nominate a small number of suitable and eligible tracts for official classification into Qualified Opportunity Zones (QOZ). The Secretary of the US Department of the Treasury certifies and designates Opportunity Zones through his delegation of authority to the Internal Revenue Service (IRS).

There are currently more than 8,000 Qualified Opportunity Zones in the US, accounting for 12% of all census tracts. Many of the areas designated as Opportunity Zones have been underinvested for decades and can be located on an interactive map on the US Department of Housing and Urban Development website. Rural areas account for just over 23% of Opportunity Zones.

Qualified Opportunity Zones - Provident 1031

The federal government developed Qualified Opportunity Zones to encourage investment and economic development, and this landmark legislation came with a slew of tax benefits for individuals who invested through a Qualified Opportunity Fund.

For those unaware, a Qualified Opportunity Fund (QAF) is an investment entity, such as a company or a partnership, created to invest in properties inside Qualified Opportunity Zones. Qualified Opportunity Funds can invest in real estate and businesses in Opportunity Zones if they fulfill specific criteria.

For example, real estate assets in an opportunity fund must be new or significantly renovated. It is not permitted to purchase existing real estate without making significant changes and improvements. Substantial improvements to a qualified opportunity zone property imply that the Opportunity Fund investments are equal to or greater than the cost of the real property and must be completed within 30 months.


What Is A 1031 Exchange?

A 1031 exchange is a real estate investment vehicle that allows investors to exchange one investment property for another while simultaneously allowing deferral of capital gains or losses and capital gains tax that would otherwise be due at the time of sale. This strategy is popular among investors who want to substantially improve their properties without paying taxes on the profits.

If you want to dive more into 1031 Exchanges, check out my articles on 1031 Exchange Real Estate Basics, The Typical 1031 Exchange Timeline, 1031 Exchange Requirements, and How Savvy Investors Use A 1031 Exchange to Defer Capital Gains and Build Wealth. I also highly recommend my free online masterclass, Master The 1031 Exchange.


Key Advantages of A Qualified Opportunity Zone

The primary tax benefit for investors in opportunity zone programs is capital gains deferral realized from prior investments.

More specifically, if an investor transfers capital gains from a prior investment into a QAF within 180 days of the sale date, the investor can defer the gain until the tax year 2026, payable in 2027.

Investors in Qualified Investment Funds can further decrease their tax liabilities by keeping their investments for at least five or 10 years. In a QOF 100% of the gains are 100% tax-free if held for the full 10 years. This gives investors a substantial edge in their wealth creation strategies.


Key Advantages of A 1031 Exchange

1031 exchanges are real estate investment vehicles that allow investors to exchange one investment property for another while simultaneously allowing deferral of capital gain taxes. While that is their most significant advantage, 1031 exchanges also come with several other benefits.

Tax Deferral

For example, investors can improve their total purchasing power through tax deferral and use the money that would otherwise go to the IRS to increase the down payment and purchase a pricier replacement property. This allows the investor to leverage their cash and grow their wealth.

Swap or Consolidate Properties

1031 exchanges are also very flexible in terms of property type. For example, investors can swap one property for another, consolidate multiple properties into a single one, or swap the existing one for several other, smaller properties.


QOZ or 1031: Which Investment Is for Me?

1031 Exchange vs. Qualified Opportunity Zones - Provident 1031 Houston - The Woodlands

Though both financial vehicles serve to defer capital gains tax for re-investment purposes, there are significant differences between QOZs and 1031 exchanges. Accordingly, the determination as to which program is preferable will be based on the investor’s goals and objectives.

Defer Taxes

Advantage:

  • 1031 Exchange
  • QOZ Fund

The 1031 exchange is the superior alternative if an investor’s primary objective is to defer taxes indefinitely and never cash out or cash out at a much later date (and pay capital gain taxes).

Realize Profits

Advantage:

  • 1031 Exchange
  • QOZ Fund

An investor wanting to realize the profits on investment at some point during their lifetime, a QOZ Fund might be a better option because a QOZ allows the basis and the cap gain to be separated. An investor may want to keep their basis for other investments or opportunities and invest only the cap gains in the QOZ. This is a distinct advantage of the 1031 exchange because in a 1031 exchange, for an investor to have a full deferral of tax, they must roll all the proceeds from the sale into a new investment.

Estate Planning Tool

Advantage:

  • 1031 Exchange
  • QOZ Fund

Since the investor can carry the taxes deferred in a 1031 exchange forward indefinitely, 1031 exchanges can be helpful as an estate planning tool. The deferred gains vanish upon passing, and if the investor held onto investment property for the rest of their life, their heirs receive a step-up basis to the property’s fair market value on the date of passing, wiping out any previous appreciation in value. These heirs can then sell the asset without incurring capital gain taxes.

However, any person who inherits an interest in a QOZ Fund before December 31, 2026, will inherit the original tax basis in the investment since QOZs don’t offer a step-up upon death. As a result, they’ll be obligated to pay the taxes; however, if the successor keeps the QOZ Fund interest until a period that’s at least 10 years from the initial investment, their tax basis will be stepped-up to the fair market value of the investment, upon disposition under the QOZ program.

Key Takeaways

  • 1031 Exchange and Qualified Opportunity Zones provide real estate investors with tax advantages.
  • Before determining which approach to take, investors need to understand the distinctions between a 1031 tax exchange and a QOZ.
  • The goal of Qualified Opportunity Zones is to encourage job creation and growth by offering tax incentives for investing in community developments in approved areas.
  • There are more than 8,000 Qualified Opportunity Zones in the United States, accounting for 12% of all census tracts.
  • The primary tax advantage for investors in Qualified Opportunity Zones is capital gains deferral from prior investments.
  • The key advantage of a 1031 Exchange is it allows investors to swap or consolidate investment properties while simultaneously allowing deferral of capital gain taxes.
  • QOZ vs. 1031 Exchange: When it comes to deferring taxes: ADVANTAGE GOES TO 1031 EXCHANGE.
  • QOZ vs. 1031 Exchange: When it comes to realizing profits: ADVANTAGE GOES TO QUALIFIED OPPORTUNITY ZONES.
  • QOZ vs. 1031 Exchange: When it comes to estate planning tool: ADVANTAGE GOES TO 1031 EXCHANGE.

1031 exchanges offer many benefits to investors, such as significant tax advantages and opportunities to grow and leverage their wealth with minimal financial liabilities. However, to fully reap the benefits and tax advantages provided by the IRC code 1031, you must adhere to its strict rules and timeframes.

If you want investment advice on 1031 exchanges in a great video learning format sign up for my masterclass, Master The 1031 Exchange. Here, you can also learn about a Delaware Statutory Trust, which can greatly enhance a 1031 exchange.

Previous Article

The Typical 1031 Exchange Timeline

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Can An LLC Do A 1031 Exchange?

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There are material risks associated with investing in DST and QOZ ( Qualified Opportunity Zones) properties and alternative real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your situation. This is not a solicitation or an offer to sell any securities. THIS IS NEITHER AN OFFER TO SELL NOR A SOLICITATION OF AN OFFER TO BUY THE SECURITIES DESCRIBED HEREIN. AN OFFERING IS MADE ONLY THROUGH DELIVERY OF THE PPM and to accredited investors only. THIS MATERIAL MUST BE PRECEDED OR ACCOMPANIED BY A CURRENT PPM WHICH SHOULD BE READ IN ITS ENTIRETY IN ORDER TO UNDERSTAND FULLY ALL OF THE IMPLICATIONS AND RISKS OF THE OFFERING OF SECURITIES TO WHICH IT RELATES. Please consult the appropriate professional regarding your individual circumstance. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses. For additional information, please contact 281.466.4843 or www.Provident1031.com. Fee-based financial planning and investment advisory services are offered by Provident Wealth Advisors, a Registered Investment Advisor in the State of Texas, and the State of Louisiana. Insurance products and services are offered through Goodwin Financial Group. Provident Wealth Advisors, and Goodwin Financial Group are affiliated companies. Provident Wealth Advisors, LLC does not offer legal or tax advice. Consult the appropriate professional regarding your individual circumstance. Securities Offered through AAG Capital, Inc. Member FINRA/SIPC. The presence of this website shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any State other than the State of Texas or where otherwise legally permitted. Important Notice - If you are investing in Alternatives your tax advisor may require you to file a tax return in the state where the subject property is located which could result in additional cost associated with your investment. Any additional expenses associated with any required tax filing are the sole responsibility of the investor/client.

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