QOF vs. 1031—Which Tax Deferral Structure Should I Use?
Qualified opportunity zones (QOZs), introduced about a year ago, have been attracting significant interest in the real estate world, with many investors and sponsors forming qualified opportunity funds (QOFs) to take advantage of the time-sensitive benefits offered under the QOZ rules.
The general idea is fairly straightforward: If, within 180 days of a sale, a taxpayer reinvests the gain amount into a QOF that acquires qualifying property within a QOZ, the taxpayer is eligible for the following tax benefits: Deferral (potentially until 2026) of tax on the capital gain reinvested into the QOF; Reduction in the amount of gain ultimately subject to tax after holding the QOF interest for five years (10 percent reduction) or seven years (an additional 5 percent); and Elimination of future tax, for a taxpayer holding a QOF interest for 10 years or more, on any appreciation in the interest’s value after its acquisition.
QOFs must be considered as an alternative to an “old” favorite tax deferral strategy, the so-called “like-kind exchange” (also known as a 1031 exchange, or simply 1031). Sponsors, financial advisers and investors are asking whether the retail market is big enough to support both deferral strategies—or whether QOFs are poised to eat the 1031 industry alive.
We believe the market will support both products. QOFs and 1031s each have certain advantages and disadvantages: thus, an investor or financial adviser will make the determination on a case-by-case basis as to what best suits the circumstances, needs and goals.
What are the QOF advantages?
QOZ investments extend beyond real property. Capital gain from any sale or exchange–including a sale of stock–may be reinvested into a QOF, whereas 1031s apply only to the sale of real property. Additionally, 1031s require the replacement investment to be in real property, whereas QOZ Investments can potentially include any trade or business located in a QOZ.
QOZ investments come with unique benefits. Investment in a QOF can reduce the gain ultimately subject to tax; for a taxpayer that plans to eventually dispose of an asset, this reduction may be preferable to a 1031 scenario (where the taxpayer, to continue to defer gain indefinitely, would need to continue to hold the asset or engage in further 1031 with no reduction available in the event that the asset is ever disposed of in a taxable sale). Additionally, an investor holding a QOZ investment for 10 years or more can dispose of the asset without tax on any additional appreciation on the asset–a major benefit which many QOFs and QOZ investors are structuring to achieve. Finally, an investor need only reinvest the gain amount into a QOF, as opposed to the entire sale proceeds in a 1031.
What are the QOF disadvantages?
No permanent deferral. The piper must be paid. In 2026, tax is owed on the gain deferred by a QOZ investment, and taxpayers must plan to pay such tax. A 1031 exchange, conversely, would permit a taxpayer to avoid gain recognition indefinitely, even potentially until the increase in tax basis on death of an individual investor eliminates the built-in gain entirely (as is common in the real estate world).
Investment must be in a QOZ. While a QOZ investment need not be real-estate-specific, it must be within a designated QOZ and generally cannot be an investment into a stabilized, already-income-producing asset. A 1031, conversely, does not involve any such limitations.
Negative basis. In the event that an investor’s gain includes the relief of significant debt (in particular, debt in excess of the investor’s tax basis), a QOF reinvestment would require the investor to come out of pocket to invest the entire gain amount. A 1031, however, permits new debt on a replacement property to effectively offset the debt relieved.
Less certainty. QOZs are novel, and while that comes with great opportunities for tax-deferred investments, guidance is still evolving and some taxpayers may prefer the certainty that comes with a more established tax deferral product.
Overall, there is no clear or right answer, and we expect both products to see significant interest and activity in the market.
Evan Hudson, Mayer Greenberg and Brian Senie are attorneys at Stroock & Stroock & Lavan.