Opportunity Zones, an Attractive Alternative to a 1031 Exchange

Qualified opportunity zone funds are proving to be an attractive alternative to a 1031 exchange, and they have already averted demand away from 1031 deals. It makes sense: 1031 exchanges and qualified opportunity zone funds have similar benefits, promising investors can avoid capital gains taxes made on an investment property; however, opportunity zone funds cover both commercial and residential investments.

“I think they have already,” Phil Jelsma, partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson, tells GlobeSt.com when asked if qualified opportunity zone funds are taking demand from 1031 exchange deals. “Not surprisingly more and more clients are asking for a comparison of the benefits of investing in opportunity zones as opposed to a Section 1031 Exchange, which allows investors to defer capital gains taxes on the sale of certain investment properties.”

Both options offer similar benefits; however, there are some notable differences. First, there are significant differences in the amount of capital required for the investment. According to Jelsma, in a 1031 exchange, the full value of the sale must be reinvested to avoid capital gains, however, in an opportunity zone fund, only the gain need be invested. 1031 exchanges are also real estate-specific, meaning that an investor must trade from a real estate investment into a real estate investment. Opportunity zone funds, however, are open to all capital gains. “Under Section 1031, your gain is deferred indefinitely but not forgiven,” he adds. “In an OZ fund, the gain on the relinquished property is deferred until December 31, 2026 and the gain on the OZ investment is forgiven if held at least 10 years.”

The timing of the investment is also different. “In addition, the timing is different. Under Section 1031, replacement property must be identified within 45 days of the sale of the relinquished property, whereas in an OZ investment, a taxpayer has up to 180 days to make the investment,” explains Jelsma. “If the relinquished property was sold by a partnership or LLC, the partnership or LLC has 180 days from the sale of the relinquished property to make an OZ investment and failing that, the partner or member has 180 days from the end of the partnership or LLC’s tax year to make the investment.” 1031 exchanges are also traced from the time of the sale, however, there is no tracing requirement in opportunity zone funds.

Geographical differences are another major distinction, since opportunity zones are investments in distressed communities. “A 1031 Exchange investment can be anywhere in the U.S, while a QOF must invest in economically distressed Qualified Opportunity Zones,” says Jelsma. “And a 1031 Exchange investment does not need to be improved, while a QOF property must be substantially redeveloped.”

Understanding these differences will help investors decide which option is a better fit for their investment goals. “Both 1031 Exchanges and Qualified Opportunity Zone Funds offer appealing investment opportunities. But it is important to remember there are many important differences between them,” says Jelsma. “A major upside of OZs is they may fuel economic activity in neighborhoods that need it most. In any event, sophisticated real estate investors need to understand the subtle distinctions between the two provisions as well as the potential benefits, liability and detriments of each regime.”