The Battle for the Throne: Opportunity Zone or 1031 Exchange?
Over the last few years, real estate values have increased, and many investors want to lock in that appreciation and sell their investment properties. One of the most common questions we are getting as CPAs is whether a 1031 exchange or Opportunity Zone is better. Let’s go over the basics of these two great tax shelters and then dive deeper to compare the pros and cons of each.
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What Is Opportunity Zone Investing?
Opportunity Zone investing is one of the hottest real estate and tax-saving buzz words right now. Cleverly named as Opportunity Zone Funds, this new tax benefit is available to investors across the nation—but just because it’s called an “opportunity” doesn’t necessarily mean it’s a good option for you.
Let’s start with the basics. The Opportunity Zone program was enacted as part of the Tax Cuts and Jobs Act. It was designed to provide tax-saving incentives for those who invest in certain designated areas throughout the U.S.
Although these areas are often referred to as "distressed communities," it does not necessarily mean the benefits are only available to abandoned buildings in the worst parts of town. In fact, Opportunity Zones can be found in many desirable areas, including coastal cities and even highly sought-after locations, such as Hawaii.
An Opportunity Zone Fund must be a special purpose entity where at least 90 percent of its assets are qualified Opportunity Zone properties.
What are the tax benefits of investing in an Opportunity Zone Fund?
There are three major benefits. The first is tax-deferral for capital gains—for example, if you sell a property and have capital gains of $100,000, you can defer paying the capital gains taxes if you reinvest the $100,000 into an Opportunity Zone Fund within 180 days from realizing this gain. Assuming your capital gains tax rate for federal and state purposes is 25 percent, this helps you to defer $25,000 of taxes into future years.
The second tax benefit is a potential reduction of taxes due on this transaction. If you hold your investment in the Opportunity Zone Fund for at least five years, you can reduce your future capital gains tax on this $100,000 transaction by 10 percent. Instead of paying taxes on $100,000 of capital gains in the future, you will only pay taxes on $90,000 of capital gains in the future.
In addition, if you hold onto this investment for at least seven years, you can exclude a total of 15 percent of your capital gains from taxes. This means that seven years later, your taxable capital gains on this transaction is reduced from $100,000 down to $85,000.
The third—and potentially most impactful—benefit is the potential tax-free growth on the Opportunity Zone Fund if the asset is held for at least 10 years. Once the investment is held for more than 10 years, the entire gain on the Opportunity Zone investment may be completely tax-free.
For example, let’s assume that you invest $100,000 of your capital gains into an Opportunity Zone Fund that owns an apartment. Ten years later, if your investment is worth $500,000, then $400,000 of the appreciation on this property could potentially be tax-free to you. Assuming a federal and state capital gains tax rate of 25 percent, you would permanently save up to $100,000 of taxes on this transaction.
Despite the obvious benefits, as with most things in the tax world, things are never as simple as they may first appear. In order to receive these tax deferrals, tax reduction, and tax-free benefits, there are a few more points to understand.
Because the government’s goal in providing this tax incentive is to help revitalize these distressed neighborhoods, simply purchasing a rental in the Opportunity Zone does not mean you automatically receive any of the tax benefits that we just described. For most rental properties, you would need to make significant improvements to the property after acquisition.
Specifically, the IRS requires that you make improvements to the property that at least double your purchase price of the building. The improvements generally need to be done within 30 months after you purchase the property. If you used your $100,000 capital gains to purchase a small rental property where the building purchase price was $50,000, you would need to spend at least $50,000 more to improve the property within the next 30 months.
As you can see, the requirement to double the purchase price of the property could mean a substantial amount of work and money. For this reason, many investors looking to receive the tax benefits of Opportunity Zone investing choose to invest into larger syndication deals rather than to take on the larger rehab projects themselves.
Beyond the improvement requirements, an Opportunity Zone Fund also has additional tax reporting requirements and testing requirements. Although we get to defer our capital gains taxes today, that tax is due either when we sell our Opportunity Zone Fund investment or when we file our 2026 tax return, whichever is earlier. If we sell our Opportunity Zone Fund investment in 2024, we would need to pay taxes on our $100,000 of deferred capital gains. Alternatively, even if we did not sell our investment by 2026, we would still need to pay taxes on this deferred gain.
What Is a 1031 Exchange?
Let's shift gears—the tax benefit of a 1031 exchange is the ability to defer your capital gains taxes on selling an investment property when you use that money to invest in replacement investment properties. Using the previous example, if you sell a rental property with $100,000 of capital gains, you can defer the capital gains taxes if you reinvest your money by buying other rentals.
Although commonly referred to as a like-kind exchange, a 1031 exchange allows you to invest in different types of investment properties. For example, you can sell a single family home and replace it with a commercial property, or you can sell an apartment building and replace it with a few single family homes or a mobile home park.
In order to have a valid 1031 exchange, you must identify which replacement properties you will purchase within 45 days of selling your relinquished property. In addition, you must close on your replacement properties within 180 days of selling your relinquished property. To defer the entire capital gains taxes on the sale of the property, you need to reinvest 100 percent of your money into your replacement properties. The purchase price of the replacement property must equal or exceed the sales price of your relinquished property.
In addition, your equity in the replacement property must equal or exceed your equity in the relinquished property—this means you cannot take any cash out of the transaction without paying some taxes. You must also work with an intermediary before you sell your relinquished property, so the money stays with the intermediary until it is used to purchase your replacement properties.
Opportunity Zone vs. 1031 Exchange: Which One Wins?
Now that we have briefly gone over the basics of the Opportunity Zone Fund and the 1031 exchange, let’s compare the two in detail to see which one may be a better strategy for you.
First, let’s go over the benefits that the 1031 exchange has that the Opportunity Zone does not. One of the major downsides of using an Opportunity Zone Fund to defer taxes is that the deferral is only available through the tax year 2026. In other words, you must pay taxes on the deferred capital gains when you file your 2026 tax return, even if you do not sell the investment.
A 1031 exchange, on the other hand, allows you to defer your capital gains indefinitely—if you continue to hold onto your investment property. In fact, even if you sell your relinquished property, you can choose to do another 1031 exchange to continue the tax deferral. There are currently no limits on the number of 1031 exchanges that you can do in your lifetime.
As a savvy investor, a great strategy may be to use 1031 exchanges to defer taxes throughout your lifetime and then get a tax-free basis step-up at death to avoid paying taxes altogether. Comparatively, an Opportunity Zone Fund investment does not receive step-up basis at death, which means that if you were to pass away, your beneficiaries may still need to pay taxes on your deferred gains.
Unlike the geographical restrictions of Opportunity Zone Fund investing, there are generally no limitations on where a 1031 exchange property may be. This means you can sell a California investment and replace that with any rental properties in Florida, Alabama, and Ohio that you liked. In a 1031 exchange, there are no requirements to significantly improve a particular property. So, unless you are looking for a property that may need quite a bit of improvement done, a 1031 exchange may be a better option.
To summarize, a 1031 exchange may be a better option for you if:
- You do not want to limit your investment to specific government-designated neighborhoods.
- You are not looking to take much cash out of the transaction.
- You are looking for rental properties that do not require substantial improvement or rehab.
- You are looking to defer your capital gains taxes indefinitely into the future.
- You are looking to pass along stepped-up basis tax benefits to your future beneficiaries.
Now, let’s switch gears to go over the Opportunity Zone benefits that are not available with a 1031 exchange. As previously discussed, you only need to invest capital gains into the Opportunity Zone Fund in order to receive the tax deferral benefit.
For example, if you purchased a rental several years ago for $50,000 and are now selling it for $125,000, you would have capital gains of $75,000. In a 1031 exchange, you would need to reinvest in properties that have a total purchase price of $125,000 or more in order to defer the taxes on the capital gains. This means you cannot take any money out of the transaction. Any money taken out of the transaction becomes taxable to you this year.
Alternatively, if you wanted to use Opportunity Zone Funds to defer your capital gains, you would only need to invest $75,000 into Opportunity Zone Funds. This means you can take and keep $50,000 from this transaction and pay no taxes on it right now. You are not required to reinvest your entire capital gains into the Opportunity Zone Funds. If you wanted to, you can invest a lesser amount into the Opportunity Zone and simply pay taxes on the un-invested portion.
This is an important benefit if you are looking to defer your taxes—while also taking cash out of your deal.
The rules for a 1031 exchange require that you sell a real estate investment and replace it with real estate investments. A 1031 exchange is not available to non-real estate transactions. Opportunity Zones, on the other hand, allow for more options. If you are someone who is selling stocks, mutual funds, or even a business, you may be able to use Opportunity Zone Funds to defer your capital gains taxes. Similarly, if you are an investor selling your rental properties but want to move that money over to other businesses, it is also possible to do that by investing in a business that is located within the Opportunity Zone, as well.
One of the benefits of the Opportunity Zone is that it does not have the 45-day identification requirement nor the requirement to use an intermediary. This means that you can sell your investment, use all of the sales proceeds to do whatever you want, and defer all of the taxes, as long as the gain amount is reinvested into the Opportunity Zone Fund within 180 days. Comparatively, in a 1031 exchange, you are not allowed to touch the money from the sale of the relinquished property.
Another great benefit of the Opportunity Zone that the 1031 exchange lacks is the potential 10 to 15 percent tax reduction and the potential tax-free growth. Although taxes on the deferred capital gains need to be paid with the 2026 tax return, a highly appreciating Opportunity Zone Fund investment can be extremely beneficial after the 10-year holding period.
To summarize, an Opportunity Zone Fund investment may be a better option for you if:
- You are looking to take out a significant amount of money from the sale of your investment property.
- You are looking to defer capital gains taxes from non-real estate transactions.
- You are looking to move your capital gains income from real estate into non-real estate assets.
- You believe the investment has significant appreciation potential, and you plan to hold this asset for at least 10 years.
As you can see, although both strategies have great tax-saving potential, there are some significant differences between the two. Both of these tax incentives can be great tools for real estate investors looking to grow their portfolio in a tax-efficient manner. When implemented correctly, they may even help to create generational tax-free wealth.
As real estate and stock values increase, it can be a great time to look at repositioning some of your assets. Before doing so, be sure to meet with your tax advisor to review your portfolio and plan ahead. Taking the time to plan now can help you keep more of your money rather than paying it to the IRS.
Considering utilizing one of these tax strategies? Which? Why?
Let’s talk below in the comment section.