Which Tax Break Is Better: 1031 Exchange or QOZ Real Estate?
Real estate investments may be structured to provide immediate tax benefits and long-term tax advantages. Investors have used Section 1031 exchanges, often known as like-kind swaps, to shift real estate assets tax-free for decades. The new Qualified Opportunity Zone program offers an additional means to defer or eliminate some taxable profits. So, is a 1031 tax exchange or a QOZ real estate investment superior?
Both choices are governed by tight IRS regulations, and some investments may qualify for both tax benefits. Before selecting one, however, private real estate investors must grasp the distinctions between these two methods and how they affect their taxable profits.
The Qualified Opportunity Zone (QOZ) program was established by the Tax Cuts and Jobs Act of 2017 to encourage investment in economically disadvantaged towns around the nation. Qualified Opportunity Zones are localities that states have designated for investment incentives based chiefly on their median income. The Opportunity Zones Act creates certain tax advantages for investors who reinvest capital gains in Qualified Opportunity Funds, which invest in opportunity zones. The Treasury Department has recognized 8,700 qualified opportunity zones where QOZ transactions may be situated, creating intense competition in regions with the most vital foundations.
The 1031 tax exchange (called after its provision in the Internal Revenue Service law) emerged from a nearly century-old incentive known as a like-kind exchange or the sale and purchase of properties of the same kind and value. Its primary objective has always been to allow taxpayers to continue holding property assets without being taxed on unrealized paper profits and losses during continuous investment. Therefore, a like-kind transaction would not result in a gain.
Before the Tax Cuts and Jobs Act, Section 1031 applied to like-kind transactions involving personal and fundamental investment properties. To evade taxes, it was feasible to engage in a like-kind trade using bitcoin, for instance. Personal possession is no longer eligible for this tax relief. Therefore, investors may no longer exchange private property, and companies can no longer replace equipment in a tax-free transaction. The like-kind exchange requirements now only apply to commercial real estate. The taxpayer’s primary residence does not qualify since it is not held mainly for investment purposes.
Tax Deferral in perpetuity: 1031 Exchanges
A like-kind exchange may delay capital gains over an entire real estate portfolio. If a couple buys a home for $70,000, sells it for $100,000, and puts all of the funds from the sale into another piece of real estate through a 1031 exchange, they can put off paying taxes on their $30,000 income. The schedule for a 1031 exchange stipulates that the investor must select the replacement asset within 45 days after the sale of the original purchase and invest the profits within 180 days. However, when the property is held in a partnership or an LLC formed as a partnership, there is an exception: individual shareholders cannot utilize their shares in an exchange since they do not own the real estate, just shares in the partnership.
Other tax advantages for real estate investors, such as depreciation, complement a like-kind transaction. For instance, the couple in the above paragraph may have claimed $2,000 in depreciation on the first property. Their cost basis for the new investment would be $68,000, or the initial purchase price of $70,000 minus $2,000 in depreciation. In subsequent years, they may deduct depreciation charges on the new property, subjecting a more significant portion of the ultimate revenues to reduced capital gains tax rates. And the date of taxation may be postponed forever if the couple keeps onto the property or re-exchanges it for a property of the same sort.
QOZ Funds: Tax Deferral through 2026 and Gain Elimination
Similar to a like-kind exchange, an investor may postpone capital gains from the sale of an appreciated asset by investing those gains within 180 days of the sale in a Qualified Opportunity Zone Fund. In contrast to a 1031 exchange, the payment must be invested to benefit from the deferral, and the option is only available for appreciating assets. There is no necessity to invest in properties of the same kind.
The postponed gains invested in a QOZ Fund become taxable on December 31, 2026, or upon the sale of the investment, whichever occurs first. While the deferral time is restricted, 10% of the postponed gain is permanently forgiven for investors who keep a QOZ Fund investment for at least five years.
The most crucial distinction between postponing a gain via a 1031 exchange and investing an increase in a QOZ Money is that if an investor retains a QOZ Fund investment for at least ten years, he or she will not pay any tax on the appreciation of the QOZ Fund investment. It bears repeating: any profits achieved on selling QOZ Fund investments or Fund assets after a 10-year holding period are tax-free.
The Ultimate Comparison: Which Is Superior?
The 1031 exchange is a deferral scheme with an indefinite length, while the QOZ program has a restricted deferral term but provides tax-free gains after a 10-year minimum holding period. Whether the program is superior will depend on the objectives of each individual investment. If an investor’s primary goal is to postpone taxes eternally and never access the investment funds, the 1031 exchange is preferred; however, if an individual desire to realize the gains on investment at some point in their existence, a QOZ Fund is preferable.
Because deferred taxes may be carried forward forever, the 1031 exchange option can be a helpful estate planning tool. The investor’s heirs get a base step-up to the property’s fair market value on the date of death, eliminating any last rise in value. These inheritors may then sell the asset without incurring a capital gain.
Under the QOZ scheme, there is no way to avoid the taxman on December 31, 2026, and anybody who inherits an interest in a QOZ Fund before that date will be compelled to pay the tax (no step-up upon death). However, if the successor retains the QOZ Fund stake for at least ten years before selling, their tax basis will be enhanced to the investment’s fair market value.
This graphic compares the timescales and criteria for the two kinds of investment structures:
| Comparing 1031 Exchange with QOZ Investments | ||
| 1031 Like-Kind Exchange | Opportunity Fund Investment | |
| Support Opportunity | Real estate owned for investment reasons (not homes) | Investing in properties in Qualified Opportunity Zones (business or real estate) |
| Investment Instrument | External custodian | Fund for Qualified Opportunity |
| Origin of Financial Gain | Must result from a commercial property sale | From the sale of any asset. |
| Timeline | Identify renewal property within 45 days of the transaction; all sale profits must be invested within 180 days. | Invest qualified capital gains within one hundred eighty days after realization. |
| Eligible Real Estate | Investment property anywhere in the United States. | Real estate located in Opportunity Zones |
| Quantity to Invest | Complete tax deferral on the whole selling profits | The total amount of capital gains |
| Deferral of Capital Gain on Investment | Until the final sale; several rollovers are possible | No later than December 31, 2026; 10% lower basis if investment held for 5 years |
| Imputed Appreciation | No tax due until the final sale; appreciation based on an initial basis | tax-free after 10 years |
| Hold Period | Indefinite | Ten years minimum for full tax advantages |
| Aspects of Estate Planning | Successors are exempt from capital gains tax. | Successors are liable for deferred capital gains tax but not for appreciation tax. |
Both 1031 like-kind swaps and QOZ real estate investments have substantial benefits and drawbacks. The superior depends on each asset’s objectives and tax planning methods. As with any investment or estate planning choice, the final decision is not based only on tax concerns.
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