The Tax Cuts and Jobs Act of 2017 made a lot of changes to the federal tax code, including the creation of a new investment category – Qualified Opportunity Zones (QOZ). These are designated areas that allow for tax-advantaged investments, similar to how 1031 exchanges function. However, the two are not identical vehicles for minimizing tax burdens, and it’s important for investors to understand the key similarities and differences.
How are they the same?
In many ways, the tax planning advantages of both Qualified Opportunity Zones and 1031 exchanges are similar. They both allow investors to defer recognition of a gain on the sale of an investment or property. They both encourage reinvestment of gains from prior investments, affectively keeping money within the marketplace, where it can bolster further growth. The primary focus area for both QOZ development and 1031 exchanges are real estate investments.
How are they different?
However, this is often where these two investment vehicles diverge.
Timeframe of gain deferral
Perhaps the primary difference between a 1031 exchange and an investment in a QOZ is the deferral timeline. For the 1031 exchange, an investor can defer tax on the gain from the original property sale until the sale of the replacement property. Alternatively, they can continue to roll the investment into a third property, and defer tax until the final property sells.
With QOZs, there is an option. QOZs allow for the deferral of tax on the gain until either the sale of the property or December 31, 2026, whichever comes first. With that in mind, 1031 exchanges may be more affective vehicles for longer-term deferral, since there is at present no deadline.
Additionally, when it does come time to pay tax on the capital gain, there is a difference in how much of it will be taxed. With 1031 exchanges, it is straightforward. When the gain is eventually realized—when the property investment is sold for cash—the investor will need to recognize the full capital gain for tax purposes.
For QOZs, if the gain is deferred long enough by holding onto the investment, the investor may be able to receive exclusions on a percentage of the gain. For example, if the investment is held for more than five years, 10% of the gain can be excluded, meaning that only 90% of the final capital gain would be taxed. If held for seven years, the exclusion ticks up to 15%.
Step up basis
If the QOZ investment is held for at least 10 years, the investor can receive the stepped-up basis on the investment. When the investment is eventually sold, the basis (or amount of original investment) is increased to the fair market value at the time of the sale. Since taxpayers are taxed on the capital gain, or difference between their basis and the sale price, this effectively makes the transaction tax-free. This does not exist with 1031 exchanges.
There are some subtle differences in the types of properties into which QOZ and 1031 exchange investments can be made.
With 1031 exchanges, replacement properties must be of a “like-kind” to the previous property sold, meaning it is “of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.” It must also be used for a trade or business or for investment. There are no geographic requirements.
Personal property (not real property) no longer qualifies for like-kind tax-free treatment, effective 1/1/2018.
With QOZs, investments must be made by Qualified Opportunity Funds into Qualified Opportunity Zones, which are government-designated distressed communities across the country. Only property in these areas qualify for the tax-deferred/tax-free treatment.
1031 exchanges follow the “like-kind” rule when it comes to the original capital investment, whereas with QOZs, any capital gain is allowed, whether from a real estate or stock market sale.
If you have questions on which investment route makes the most sense for you, contact your MCM professional or MCM Tax Partner Karl Dostal, CPA, CFP via e-mail or phone (513.768.6782), or MCM Senior Tax Manager Ashley Barke, CPA via e-mail or phone (502.882.4315).