Are Qualified Opportunity Funds or 1031 Exchanges Right for Me?
Qualified Opportunity Funds (“QOFs”), created as part of the Tax Cuts and Jobs Act, can create significant benefits to investors. But, are OQFs a better investment opportunity than a comparable 1031 exchange? There are important differences to consider before choosing the right investment method for your situation. You should consider your frequency of investing, what your main goals are, how much investment you have in real estate versus other assets and whether you are willing to invest for the long term. Consider the following benefits and implications of both QOFs and 1031 exchanges to further understand your options.
Qualified Opportunity Funds
The major benefits of QOFs are the deferral and reduction of current capital gains tax and the potential elimination of capital gains tax on future appreciation. If you hold the investment in a QOF for five years, you can reduce your deferred capital gains tax liability by 10% and receive a step-up in basis, and if you hold the investment for seven years, you will receive an additional 5% reduction. For example, if you hold a capital gain rollover $1,000,000 investment in a QOF for seven years, 15% of the total deferred capital gains would be excluded from U.S. federal income tax, and you would pay the capital gains tax on the remainder of the deferred gain of $850,000 in 2026. If the investment is held for at least 10 years, the appreciation above the $1,000,000 investment is permanently excluded from capital gains taxation provided the disposition occurs prior to 2048.
The reinvestment window for a QOF investment is the same as a 1031 exchange – 180 days after the sale. There are instances where you are allowed additional time to reinvest. For example, if you are a partner in a partnership that has realized capital gains from the sale of assets, the partnership has 180 days to invest those gains in a QOF. If the partnership does not pursue a QOF, you as the partner have 180 from the partnership’s year end, usually December 31, to invest your allocable share of capital gains into an OZ, or June 30.
Unlike with a 1031 exchange, another benefit to a QOF is that, long or short-term, you can invest capital gains realized from any type of capital asset sale, into a QOF, i.e., capital gains from the sale of stock. With a 1031 exchange, you can only reinvest net proceeds from the sale of real estate.
Additionally, with a QOF, in order to defer the gain you must reinvest the capital gains from the sale but with a 1031 exchange, you need to reinvest the entire net proceeds.
Although the new QOF offers multiple benefits, for some real estate investors, a 1031 exchange might be a better investment over time. One benefit to a 1031 exchange is the ability to defer tax on capital gains and continue to keep rolling over the deferral through future sales into additional 1031 exchanges. With a QOF, the tax on the deferred capital gain is due upon the earlier of the disposition of the investment in the QOF or 2026.
Additionally, 1031 exchanges can be a powerful tool when estate planning. If the right planning is done, the capital gains tax on the deferral will be eliminated due to the step up in basis to fair market value on the date of death. Therefore, no tax would be due on the original deferral.
Choosing Your Best Option
There are benefits and drawbacks to either investment method. Depending on frequency of investing, what your main goals are, and how much investment you have in real property versus other assets, you may prefer one method over another. The chart below highlights main differences between QOFs and 1031 exchanges.
|Qualified Opportunity Funds||1031 Exchanges|
|Must reinvest in a QOF in 180 days*||Must reinvest in real estate in 180 days|
|Reinvestment does not have to be like-kind property||Reinvestment must be real property|
|Reinvest capital gains||Reinvest net proceeds|
|Must pay deferred gain – not best for estate planning||Able to completely defer gain – better use for estate planning|
Because QOFs are newly created, unlike 1031 exchanges that have been in play for some time, investors could run into areas of limited guidance or misunderstanding due to still unanswered questions. Although proposed regulations were released in October 2018, additional guidance is forthcoming, especially in regards to investment in operating businesses.
To determine the investment method that benefits you the most, you must take a look at your individual situation. Once you have determined your priorities and your current and future investment plans, you can easier choose your best investment option.
Author: Carol Surowiec. As a Tax Partner with Cherry Bekaert’s South Florida practice, Carol brings over 30 years of public accounting experience in tax planning and compliance services. Carol’s comprehensive strategic tax planning experience includes partnerships, S corporations, closely held entities and individuals. In addition, she serves multinational companies focusing on the real estate and construction, as well as manufacturing and distribution sectors. Her expertise includes compliance, consulting and tax guidance. Carol also has significant experience advising entrepreneurs and high-net-worth individuals on tax strategies to assist in minimizing tax exposure.