For real estate investors, the investment vehicle known as a 1031 Exchange has provided one of the most appealing tax breaks on the market. But a recently introduced program called Opportunity Zones has presented new tax benefit options that are turning the heads of investors.
The program allows investors to join an Opportunity Fund to receive similar tax breaks to that of a 1031 Exchange; however, there is one distinguishing feature of an Opportunity Fund that is particularly enticing—the ability to completely eliminate capital gain taxes on the growth of your investment.
That’s exciting! But does that mean it’s better for real estate investors to take advantage of an Opportunity Fund rather than a 1031 Exchange? Below we’ll unpack the differences between these two investment structures in more detail to help you make the best choice for your portfolio and get the tax benefit that will build the most wealth.
Before we contrast the two investment vehicles, let’s look at the basics of their design.
The idea behind Opportunity Funds is to invest a minimum of 90% of the capital into Opportunity Zones—zip codes around the country that the government has determined as “underdeveloped” and ripe for economic growth. Investors who roll capital gains from the sale of an asset into an Opportunity Fund can defer paying tax on it until the end of 2026. They even have the ability to reduce the amount of tax they have to pay on that original capital gain—up to 15%. But, again, the primary benefit is that investors can get rid of capital gains tax on the growth of what they invest in the Opportunity Fund if they stay invested long enough.
A 1031 Exchange, also known as “swapping” or a “like-kind” exchange, gives investors the ability to put off paying capital gains tax by reinvesting their earnings from the sale of a piece of real estate into a similar type of property. This gives investors more buying power by protecting the gross equity they earned from a piece of investment property.
Now that we know their basic designs, let’s break down the differences between Opportunity Funds and a 1031 Exchange so you can see which is best for you.
With an Opportunity Fund you only have to invest the capital gains (not the principal) of a recently sold asset to get the tax break, and you can do this directly. A 1031 Exchange requires you to reinvest capital gains along with the principal through a qualified intermediary.
You can invest in an Opportunity Fund using capital gains from the sale of any type of asset (stocks, bonds, real estate, etc.), but a 1031 Exchange requires capital gains from the sale of real estate.
An Opportunity Fund can invest in a number of asset types (real estate, businesses, etc.), while with a 1031 Exchange your investment is limited to one property—unless you jump through hoops and high costs.
Until the end of 2026, an Opportunity Fund allows you to defer capital gains tax on your original investment. Meanwhile, a 1031 Exchange has no time limit. You’ll just have to pay capital gains tax on the final sale of the asset; however, if you die while still invested, the inheritor in your estate plan continues to receive the tax deferral so long as the asset stays invested.
A 1031 Exchange doesn’t offer a capital gains tax-base reduction (unless it’s through a step up in basis upon inheritance). But if you stay invested in an Opportunity Fund for 5 years, your original capital gains tax is reduced by 10%. If you stay invested for 7 years, it’s reduced by another 5%. That’s a total reduction of 15% if you invest before the year 2020 hits—so connect with an investment professional who can get you started with an Opportunity Fund today!
As mentioned earlier, with a 1031 Exchange, you’ll pay capital gains tax on the final sale of the asset. With an Opportunity Fund, you can completely avoid capital gains tax on the growth of your investment if you stay invested for 10 years or more! An Opportunity Fund can also resell investments and still take advantage of the tax benefits as long as:
We get many questions on whether 1031 Exchanges can be combined with Opportunity Funds. For now, this remains a timeline challenge. For example, it’s possible to roll over funds from a 1031 Exchange into an Opportunity Fund, but the challenge of managing the timeline requirements of a 1031 Exchange along with an Opportunity Fund and project timelines will make it a rare occurrence.
So there you have it—1031 Exchanges offer many great tax benefits, especially to real estate investors who like a more hands-on approach. Opportunity Funds are also taking a strong stand by allowing investors to eliminate capital gains tax on the appreciation of funds over a 10-year term so their money can grow tax-free.
If you’re considering investing in an Opportunity Zone, make sure you get all the information you need to make a decision on whether or not an Opportunity Fund is for you—before the end of 2019 if you want to take advantage of the full tax reduction benefits.