When it comes to real estate investing, 1031 Exchanges and Qualified Opportunity Zone Funds (QOZF) are two attractive options. Both programs help investors trade assets while deferring taxable profits by reinvesting gains from selling one property into buying another.

Although both 1031 Exchanges vs. Qualified Opportunity Zone (QOZ) Funds look similar, you must know some key differences before choosing one. These differences determine whether or not either of these real estate investment alternatives fits your goal. Get small business bookkeeping services for better understanding.

So, in this blog, we’ll take a closer look at both of these programs.

Let’s get started:

What are Section 1031 Exchanges?

Section 1031 Exchange is a program by Internal Revenue Code (IRC) that allows investors to defer capital gains taxes as long as they reinvest them into another property that is "like-kind" to the one which was sold. This century-old method is also known as like-kind exchanges, Starker exchanges, and Starker Loophole.

Let’s understand it with an example:

Suppose you buy a residential property for $100,000. Then, after ten years, you sell the property at $200,000 (double the purchase price). Now, you don't want to pay taxes on your gain, i.e., $100,000. So, to defer the tax, you can follow the Section 1031 Exchange and use the proceeds (money from the sale) to buy another real estate property of equal or greater value.

You can keep doing this for the rest of your life. Eventually, when you die, your heirs inherit the property on a stepped-up basis.

Key benefits of 1031 Exchanges

● Indefinite deferral of capital gains tax as long as you follow all the rules properly.

● Easier estate planning due to the stepped-up basis to the asset's market value.

● You can buy a property anywhere in the U.S. So, you have a variety of replacement options for the upleg of a Section 1031 exchange.

What is a Qualified Opportunity Zones Fund?

First of all, what are qualified opportunity zones (QOZ)? Opportunity zones are economically distressed communities that need investment and revitalization.

A QOZ Fund is an investment vehicle organized as a partnership or corporation for investing in QOZ property. The property should hold at least 90% of its assets in QOZ property. This program was introduced as part of the Tax Cuts and Jobs Act of 2017. It aims to encourage long-term investments in low-income communities across the U.S. As of January 2023, there are a total of 8,766 Opportunity Zones across the country.

Investors who choose this program can defer tax on prior gains that are invested in a Qualified Opportunity Fund (QOF) until December 31, 2026.

Key benefits of Qualified Opportunity Zones Fund

● Diversify your investment portfolio across classes such as local businesses, infrastructure development, along with real estate. Get help from local CPA for small business.

● Easy process, and no qualified intermediary is involved

● You’ve 180 days to make an informed investment decision according to your return objectives.

Section 1031 Exchanges vs. Qualified Opportunity Zone Funds

Which is better for you in different scenarios

● Exist the real estate business - QOF

In this scenario, a Section 1031 exchange won’t work because you’ve to keep exchanging one property for one or more like-kind properties. These include business and investment real estate, apart from residential properties. So, you’re always a landlord with all responsibilities the role entails.

On the other hand, investing in a QOF doesn't require you to manage anything. Instead, it's the QOFs - which are LLCs, partnerships, or corporations - that pool money from investors, invest in the property, and manage it themselves.

So, if you don’t want to be a landlord anymore, put your money in a QOF.

● Diversify your investment portfolio - QOF

Choose a QOF if you want to diversify your real estate investment portfolio. You can invest in multiple QOFs, many of which have multiple properties in multiple QOZs.

● Defer long-term capital gains - Section 1031 Exchange

With a Section 1031 Exchange, you owe no tax as long as you keep exchanging for replacement property of equal or greater value.

On the other hand, capital gains from QOF investments are tax-deferred only until December 31, 2026. So, on this date, you'll have to pay your capital gain tax.

● Sell the property in 10 or more years - QOF

Although a Section 1031 Exchange is tax-deferred, but not tax-free. When you ultimately sell your replacement property, you pay profit tax on the difference between the value of your original property and the sale amount of the replacement property.

Contrastingly, when it comes to QOF, the property's basis is increased as per the market value at the time of the sale, given that you held it for at least ten years. So, you owe no tax. In addition, you may hold a QOF until 2047 while avoiding gains tax.

● Your heirs should inherit the property tax-free.

Section 1031 Exchange is ideal here because deferred taxes can roll indefinitely until the property owner dies. Heirs get a step-up basis equal to the property's fair market value at that time, and they can sell the property tax-free. In contrast, a QOF investment doesn't offer the step-up upon death benefit. Get in touch with a tax preparer Rancho Cucamonga for more details.

Final Words

If you're looking for a hassle-free and simple way of investing in real estate, then choose QOF. Section 1031 exchanges involve a lot of rules, while QOF is relatively simple. But if you're cautious about investing in low-income opportunity zones, then go for a Section 1031 exchange. This lets you invest in almost any real estate property across the U.S.

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