Oppotunity Fund vs. 1031 Exchange
Real estate investors have had the 1031 Exchnage program, one of the most tax efficient investment vehicles availabe for many years, but it's no longer the only game in town. Please welcome the new player; Opportunity Funds. Investors not only have the ability to defer and reduce their iniital capital gains tax exposure, but are also able to eliminate all capital gains taxes on the profits while invested in an Opportunity Fund as long as certain conditions are met. Here we are examining the differences between the two options.
1031 Exchanges - Allow investors to defer paying capital gains tax on the sale of a property by reinvesting the proceeds directly into a new property.
Opportunity Fund - An alternative investment that aims to invest at least 90% of Assets Under Management (AUM) into Qualified Opportunity Zones. The benefits include a deferral of capital gains tax on the asset sale until 2027 and the possibility of a full exemption from capital gains on investment gains inside the fund.
1031 Like-Kind Echange
Opportunity Fund Investment
||The principal and capital gains must be reinvested within 180 days of sale.
||Only capital gains must be reinvested withing 180 days of sale to qualify for the tax advantages. An investor is not required to roll over the entire gain and the funds must be directly invested into a Qualified Opportuntiy Fund.
||Only real estate qualifies for a 1031 Exchange.
||Capital gains from the sale of real estate or another investment will qualify for an Opportunity Fund.
||Mainly designed for single asset swaps. An investor can support a multi property swap thrugh certain structures, but they generally come with high costs and fees, and can be fairly inflexible in what options are available.
||Pooled investment fund.
|Capital Gains Tax Deferral
||Capital gains tax payments for the initial investment may be deferred indefinitely.
||Tax payment on capital gains of the initial investment may be deferred until April 2027.
|Capital Gains Tax Reduction
||No capital gains reduction is available except through a step up in basis upon death.
||Capital gains tax on the initial investment is reduced by 10% after 5 years and by another 5% after 7 years through step up in basis. In total, a 15% reduction is possible (as long as an investor invests by December 31, 2019).
|Capital Gains Tax on Final Sale
||An investor owes capital gains tax on final sale of the asset.
||If the investment is held for at least 10 years, the investor can expect to owe no capital gains tax on any appreciation of the initial opportunity fund investment upon sale of such investment.
Capital Gains Tax Reduction
- 1031 Exchange - Best used for single asset swaps and real estate investors who want to be very hands on with the managemet of their properties. Opportunity Funds offer a way for more passive investors to potentially benefit from significant tax benefits.
- Opportunity Funds - Pooled fund; multiple investors are able to aquire a portfolio of assets as opposed to just a single building swap. Diversification usually helps to reduce risk, and also the tough work of finding the deals and acquiring and managing assets doesn’t fall on the shoulders of the investor, but on the fund manager.
Tax Upon Sale
- 1031 Exchange - 1031 exchange will not reduce a tax on capital gains, but can help defer the capital gains taxes owed. A tax basis step up is possible for inheritances.
- Opportunity Funds- An investment offers a step up in an investors tax basis giving investors the ability to defer paying capital gains taxes on their initial gain as well as reduce their tax bill when it comes due. Holding an investment for 5 years will reduce your capital gains tab by 10%. A 7 year investment will reduce capital gains tax liability by a total of 15%. On December 31, 2026 the tax benefit runs out at which point the original capital gains tax bill is triggered, with the tax liability being due in 2027.
- 1031 Exchange - Upon final disposition, investors will be taxed on their capital gains in full; assuming that the disosition happens while the investor is living.
- Opportunity Funds- This structure offers investors a permanent exclusion for any gains realized on their initial investment if that investment is held for a minimum of 10 years.
Which option is best for an investor?
That's a difficult question and one that should involve conversations with a personal tax and/or estate planning expert.
- These vehicles are best suited for passive investors who are looking to diversify their portfolios.
- Any sale from stocks, bonds, or real estate can be invested.
- This structure is best for investors with a medium time horizon who would like access to their principal from the prior sale.
- Best for active real estate investors with resources and expertise.
- Solely for investors with a gain stemming from a real estate sale.
- Investors who do not need acccess to their principal capital.