Plus: Considerations to Help Determine When to Use Which
When it comes to building generational wealth, it’s not about what you earn but what you keep. Taxes matter.
To trade real estate assets without triggering capital gains taxes, investors have a long history of using 1031 exchanges. The Opportunity Zone program offers another way to manage taxable capital gains. Both strategies can offer meaningful tax advantages, yet they differ in important ways. Here, we discuss four key differences and share considerations that may help investors determine when to use which option.
The Basics
1031 exchange – When an investment property is sold for a gain, investors generally must pay tax on the gain at the time of sale. Internal Revenue Code Section 1031 provides an exception, allowing investors to postpone paying tax on the gain if they reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
Opportunity Zone program – The 2017 Tax Cuts and Jobs Act established the Qualified Opportunity Zone program, an initiative designed to lift Americans out of poverty and revitalize struggling areas. The program spurs economic development and job creation in more than 8,700 census tracts by offering significant tax advantages to those investing certain eligible capital gains into Opportunity Zones through Qualified Opportunity Funds.
Key Difference #1: Eligible Source of Gains
Only real estate gains are eligible for 1031 exchanges.
With the Opportunity Zone program, gains from any type of asset sale (real estate, stocks, bonds, cryptocurrencies, businesses, etc.) as well as 1231 gains may be eligible for investment in a Qualified Opportunity Fund.
Key Difference #2: Tax Deferral Period
With 1031 exchanges, investors can defer capital gains taxes indefinitely.
With the Opportunity Zone program, investors can defer taxes from the original asset sale through December 31, 2026, or when the investment in the Qualified Opportunity Fund is sold, whichever comes earlier. In most cases, the tax payment for the eligible gain would be due in 2027 when the taxpayer files a return.
Note: It’s possible that new legislation could extend the year-end 2026 deadline.
Key Difference #3: Capital Gains Tax Elimination
With 1031 exchanges, capital gains taxes are eliminated with a step-up in basis to fair market value for the property’s heirs when the owner dies.
With the Opportunity Zone program, the investor can eliminate capital gains taxes before death. If an investor holds their Opportunity Zone investment for at least 10 years, then any capital gain appreciation earned from the Opportunity Zone fund investment is not taxed upon disposition. This is the most significant tax benefit provided by the Opportunity Zone program. As it currently stands, the program won’t sunset until 2047, giving investors with long time horizons many years to let their Opportunity Zone investments grow.
Key Difference #4: Investment Strategy and Location
Investors using 1031 exchanges can choose a like-kind replacement property in any location and pursue any type of real estate investing strategy.
The IRS requires Qualified Opportunity Funds to buy assets in certain locations and pursue heavy renovations, adaptive reuse, or ground-up construction—all of which are considered value-add or opportunistic real estate investing strategies. These are generally deemed the riskiest categories of real estate investing, but they also offer the highest upside potential and highest rate of targeted return.
Many Qualified Opportunity Fund sponsors (including Caliber) combine a value-add or opportunistic strategy with a more conservative, “core”-like level of debt by borrowing 50% or less against the value of the assets. These funds combine the lowest level of debt risk with the highest level of execution risk, creating a blended rate of return that offers investors an attractive upside without putting their capital at a high level of risk.
Considerations to Help Determine When to Use Which
Both 1031 exchanges and Opportunity Zone investments involve multiple regulations and strict timelines. These transactions require input from knowledgeable tax, legal, and financial professionals. While the points above summarize key differences, it’s important to realize other differences and nuances exist and should be carefully considered—for example, taxable “boot” which can arise from reinvesting partial sale proceeds in a 1031 exchange, the need to identify replacement properties within 45 days in a 1031 exchange, and the possibility of investing in businesses located within Opportunity Zones.
Ultimately, deciding which option to use depends on each investor’s individual circumstances. Considerations which could be helpful in making the decision include:
- Suitability of underlying investment strategy and location – What type of risk-return profile are you seeking? If a conservative, core-like investment strategy is most appropriate for your portfolio, you may find a wider field of suitable choices via 1031 exchange. On the other hand, investors seeking greater potential returns or those seeking to support community development may find more suitable choices via the Opportunity Zone program.
- Source of capital gains – Do you have gains sourced from non-real estate assets? If so, the Opportunity Zone program is likely your only option.
- Do you need to access the gains in your lifetime? If you eventually need to convert your gains to cash, the Opportunity Zone program may be worth considering. On the other hand, if you have an estate planning focus, then a 1031 exchange may be an appropriate solution.
Caliber is active in both Opportunity Zone investments and 1031 exchanges.
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About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, including estimated costs to complete assets under development, Caliber’s 15-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: invest in Nasdaq-listed CaliberCos Inc. and/or invest directly in our Private Funds.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
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