Qualified Opportunity Zones (QOZs), created as part of the Tax Cuts and Jobs Act (TCJA), can create significant benefits for investors. But, are these investment vehicles a better investment opportunity than a 1031 exchange? There are important differences to consider before choosing the right investment method for your situation.
For instance, 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 QOZs and 1031 exchanges to further understand your options.
Qualified Opportunity Zones Defined
Per the Internal Revenue Code (IRC), a QOZ, broadly, is a geographical area that has been deemed “economically distressed” through a nomination process (see additional information at the Internal Revenue Service (IRS) website). States, U.S. territories or the District of Columbia (D.C.) can recommend a community be qualified as an Opportunity Zone (OZ). If approved, the IRS and U.S. Treasury will certify the nomination, making it official.
The OZ designation was designed to help generate economic development in underserved areas and increase job creation. It uses preferential tax treatment to incentivize investors to start projects in OZ communities.
Using Qualified Opportunity Funds To Invest in a QOZ
To invest in a QOZ, investors will need to use an investment vehicle, called a Qualified Opportunity Fund (QOF). QOFs are either partnerships or corporations who are required to file federal income tax returns to claim their investment in QOZ property. In other words, to invest in QOZ property, an investor will need to invest in a QOF.
There are three major benefits of QOFs:
- Reduction of current capital gains based on length of time invested
- Deferral of the original capital gains until a defined future period
- Potential elimination of capital gains tax on future appreciation based on the holding period of the QOF
The first benefit of a reduction in current capital gains is summarized below:
|
Investment Period |
Holding Requirement |
Tax Benefit |
| Before December 31, 2019 | Seven years | 15% step-up in basis (no longer available) |
| Before December 31, 2021 | Five years | 10% step-up in basis (no longer available) |
| 2022 – 2026 | Less than five years | No step-up available |
| After December 31, 2026 | Five years | 10% step-up in basis (30% if rural*) |
* A qualified rural opportunity fund, very generally, is a QOF that holds 90% of its assets in QOZ property the substantial use of which takes place in a city or town with a population of 50,000 fewer.
For a deeper dive into how the 2025 Tax Reform reshaped OZs, see our article Opportunity Zones Extended.
Example: How QOF Tax Benefits Work Over Time
For example, if you generated a $1,000,000 capital gain in 2027 and invest in a QOF for five years, 10% 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 $900,000 in 2032. 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 at the time of disposition or the basis is stepped up to fair market value at the 30-year holding anniversary.
1031 Exchanges Defined
While QOZs offer unique tax incentives, they aren’t the only deferral tool available. A 1031 exchange, also referred to as a like-kind exchange or Section 1031 exchange, is a type of real estate transaction that allows the property owner to defer the capital gains tax by reinvesting the proceeds of the sale of real estate into a similar (like-kind) property.
To qualify, the property must meet specific criteria, including:
- Both the sold and purchased property must be used for a business or investment purpose. For example, primary residences or second homes do not qualify for this tax benefit.
- Both properties must be considered real property per the IRC and regulations; however, the type of real estate does not matter — an investor could exchange vacant land for a residential rental property.
- Both properties must be in the U.S. You cannot exchange a property for one that is outside U.S. borders.
In addition to property requirements, there are also other requirements that the transaction must meet to be eligible for a 1031 exchange. First, proceeds from the property that is sold must be held by a qualified intermediary. Second, potential replacement properties must be identified within 45 days of the sale date of the relinquished property. Third, the purchase of the replacement property must be completed within 180 days after the sale of the prior property.
There are exceptions to these time limits depending on when the prior property is sold.
Example: How 1031 Exchanges Benefits Could Work Over an Individuals Lifetime
For example, Investor B sells a rental property and realizes a $1,000,000 capital gain and uses a 1031 exchange to reinvest all proceeds into another like-kind property. This defers the capital gains tax on the original sale. Over the years, Investor B continues to use 1031 exchanges to roll the investment into new properties, each time deferring the capital gains tax on the original $1,000,000 AND any gain on the replacement property when sold.
Eventually, upon Investor B's death, the estate’s basis in the property receives a step-up to the fair market value of the property at the date of death. This step-up eliminates the deferred capital gains tax entirely, meaning no tax is due on the original $1,000,000 gain or any of the gains that would have been realized on subsequent sales that were rolled into 1031 exchanges. This example illustrates how 1031 exchanges can be a powerful tool for long-term tax deferral and estate planning.
1031 Exchange vs. Opportunity Zone: Compare and Contrast
Even though both 1031 exchanges and QOZ investments can offer deferred capital gains, they also both come with benefits and drawbacks. Learn more about each option’s pros and cons to help you understand which one may better suit your priorities.
1031 Exchange Pros and Cons
Although a QOZ investment 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 original deferral through future sales into additional 1031 exchanges.
Conversely, while gain on the disposition of a QOF investment can be deferred, the originally-deferred gain in connection with an initial investment is required to be recognized in a relatively short period of time. Both can be powerful tools 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.
QOF Pros and Cons
The reinvestment window for a QOF investment is the same as a 1031 exchange — 180 days after the sale or deemed allocation of capital gains from a partnership. There are instances where you are allowed alternative times to reinvest. We recommend you consult with a tax professional knowledgeable about OZs to explore options on the timing of investments. Keep in mind:
- For QOF investments made prior to January 1, 2027, the tax on the deferred capital gain is due upon the earlier of the disposition of the investment in the QOF or 2026.
- For QOF investments made on or after January 1, 2027, the tax on the deferred capital gain is due upon the earlier of the disposition of the investment in the QOF or five years from the date of the gain event.
Unlike with a 1031 exchange, another benefit to a QOF is that, long or short-term, you can generally invest capital gains realized from any type of capital asset sale, into a QOF (i.e., capital gains from the sale of stock, secondary residence, business sale, etc.). With a 1031 exchange, you can only reinvest net proceeds from the sale of certain real estate.
Additionally, with a QOF, in order to defer the gain, you can reinvest some or all of the capital gains from the sale, but with a 1031 exchange, you need to reinvest the entire net proceeds before debt repayment to avoid taxation.
Choosing Your Best Real Estate Investment Option
Depending on the 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 the main differences between QOFs and 1031 exchanges.
|
Feature |
Qualified |
1031 Exchanges |
| Reinvestment Deadline | 180 days from gain recognition (some exceptions if gain is from a flowthrough entity) | 45-day identification period, total of 180 days from property sale to complete |
| Asset Type Eligibility | Capital gains from any asset (e.g., stocks, business sale) | Only real estate |
| Like-kind Requirement | Not required | Required (must be real property) |
| Tax Deferral Period | OZ 1.0: Until earlier of QOF disposition or December 31, 2026 OZ 2.0: Earlier of QOF disposition or five years after the original gain event |
Indefinitely, if reinvested through future exchanges |
| Step-up in Basis | Available if held for five to seven years (based on investment date) for investments made before January 1, 2027, five years for investments made on or after January 1, 2027 | Available at death for estate planning |
| Tax-free Appreciation | Yes, if held for 10+ years | No, appreciation is taxed upon sale |
| Estate Planning Advantage | Strong (gain can be eliminated at death) | Strong (gain can be eliminated at death) |
| Flexibility for Failed Exchanges | Can be used after a failed 1031 exchange | Not applicable |
| Complexity & Guidance | Newer program with evolving rules, thus there are areas in which there is limited or no guidance | Well-established with clear IRS guidance |
To determine the investment method that benefits you the most, you must look at your individual situation. Once you have determined your priorities and your current and future investment plans, you can more easily choose your best investment option.
Case Study: Comparing Outcomes
Investor A sells stock with a $1M capital gain on October 1, 2027. The investor invests the full gain in a QOF. After five years, 10% of the deferred gain is excluded from tax, and the remaining $900,000 is taxed at that point. If held for 10 years, any appreciation through year 30 above the original $1M is tax-free.
Investor B sells rental property and uses a 1031 exchange to defer the gain by reinvesting all proceeds received into another property. Over time, they continue rolling proceeds into new properties. Upon death, the estate receives a step-up in basis, eliminating the deferred tax entirely.
Can You Turn a 1031 Exchange into an Opportunity Zone Investment?
When comparing these two investment options, you might wonder if you can convert a 1031 exchange into a QOF to get the best of both investment types. Unfortunately, there is no easy process for investing proceeds from a sale of real property into a similar QOZ property to claim a 1031 exchange deferral.
A 1031 exchange requires the proceeds to be used to purchase replacement property. OZ investors are required to invest cash in a fund which is structured as either a partnership or corporation. Because the OZ deferral requires a fund, the 1031 requirement of “like-kind property” cannot be met. Instead, the investor would have to forgo the 1031 exchange and use the proceeds to invest in the QOF.
Alternatively, OZ investments can be a great tool upon exit of a prior 1031 exchange or a failed exchange, most often caused by failure to identify or close on the replacement property in the prescribed timeframe.
Opportunity Zones vs. 1031 Exchanges: Frequently Asked Questions
Not simultaneously for the same gain. A 1031 exchange requires reinvestment into like-kind real estate, while a QOF requires investment into a fund structure. However, you can use a QOF after a failed 1031 exchange, partially taxable 1031, or when exiting a 1031 investment.
Generally, capital gains from the sale of any asset — stocks, business interests or real estate — can be invested in a QOF. Additionally, capital gains recognized in connection with certain non-sale transactions are eligible. This flexibility is one of the key advantages over 1031 exchanges, which are limited to real estate.
You’ll still benefit from deferral and possibly a step-up in basis (if held for five or seven years depending on investment date), but you won’t qualify for the tax-free appreciation benefit available after 10 years.
You may be able to reinvest the capital gains into a QOF, provided you meet the 180-day reinvestment window. This can be a strategic fallback option.
Your Guide Forward
No matter if you decide to use a 1031 exchange or invest in an Opportunity Zone, Cherry Bekaert’s tax professionals can help guide you through the process. Reach out to our OZ or Real Estate Industry team to learn more about what type of investment would better suit your situation.
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