Real estate investors have long benefitted from the ability to defer income taxes on the sale of investment property via a 1031 like-kind exchange. Recent tax laws enacted under the Tax Cuts and Jobs Act of 2017, have given real estate investors another alternative to consider when it comes to deferring income taxes on the sale of real estate called Qualified Opportunity Funds (QOFs).
QOFs offer taxpayers who invest in areas designated as Qualified Opportunity Zones the ability to not only defer income tax on capital gains, but to increase the basis of the QOF after certain holding period requirements are met. Let’s compare aspects of the two tax deferral strategies and look at some reasons why an investor might prefer one over the other.
Asset Sale
For a 1031 exchange to be an option, the relinquished (sold) property and replacement (bought) property must be “like-kind” investment property. A QOF allows deferral of capital gains for any asset being sold at a capital gain, not just investment properties. This means investors can sell shares of stock, a business, or real estate that would not otherwise be eligible for a 1031 exchange (i.e. primary residence, vacation home) and still reap tax benefits from reinvesting in a QOF.
Tax Deferral
A successful 1031 exchange allows for potentially unlimited tax deferral and the opportunity for a step-up in basis at death. QOFs allow investors to defer paying capital gains taxes until the earlier of December 31, 2026 or the date the QOF is sold, with no step-up in basis at death because it is considered income in respect of a decedent (IRD). Looking at tax deferral alone, the 1031 exchange holds a clear advantage over QOFs which have a hard date as the maximum deferral period.
Basis Step-up
While assets acquired via a 1031 exchange are eligible to receive a step-up in basis at death, QOFs are eligible for a partial basis step-up of the deferred gain based on holding period. After holding the QOF for 5 years, 10% of the deferred gain can be added to the basis. After holding the QOF for 7 years an additional 5% of the deferred gain can be added to the basis of the QOF. However, to be eligible for a combined 15% step-up in basis on the deferred gain, the QOF must be invested in by December 31, 2019.
In addition to partial basis step-up of the deferred gain, QOFs offer investors with a holding period of at least 10 years the ability to make the basis of the QOF equal to its fair market value when it is sold. This tax break could be substantial for QOFs with high appreciation, but this step-up does not apply to the deferred gain, only the gain on the QOF itself.
Reinvestment of Proceeds
Both the 1031 exchange and QOF rules require investors to reinvest (in either the replacement property or the QOF) within 180 days. The 1031 exchange requires all proceeds be reinvested in a replacement property of equal or greater value and the proceeds must be held by a qualified intermediary.
The QOF offers greater flexibility in that it allows investors to reinvest an amount less than the gross sale proceeds and still take advantage of all its tax benefits. No qualified intermediary required. Investors can split basis and gain on the sale of an investment property. The basis can be taken tax-free while gains are invested in a QOF to achieve tax deferral. The tax-free return of basis affords investors more options with their money whether it be pay taxes on the 2026 capital gain while continuing to own the QOF, reinvest in non-QOF real estate, diversify into stocks and bonds, or just flat out spending the money.
State Tax Laws
While most, if not all, states conform to the federal tax laws on 1031 exchanges, there are some states such as California that do not conform to federal tax laws on QOFs. For California taxpayers, the federal tax benefits of QOFs are still available, but state income taxes to California are due for the year of a sale even if proceeds are reinvested in a QOF.
Conclusion
For real estate investors looking to simply defer taxes and continue to stay invested in real estate, 1031 exchanges continue to offer superior tax benefits to QOFs because of the potentially unlimited tax deferral with a step-up in basis at death. However, QOFs offer a tax advantaged exit strategy and could be a better option for investors willing to pay some taxes, invest some (or all) gain into Qualified Opportunity Zones, and ultimately do something else with their money beyond invest in real estate. As with any investment, investors should consider the non-tax, investment merits of a QOF first and foremost.
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