1031 Exchanges or Qualified Opportunity Zones?

“I want to sell my investment property, but I don’t want to pay taxes right now.  What are my options?” 

As real estate attorneys, we run into this question quite often.  For many years, investors have relied almost exclusively on 1031 exchanges to defer the recognition of gain on the sale of their real property.  However, with the passage of the One Big Beautiful Bill Act in 2025, there has been renewed interest in achieving similar tax deferral through investments in Qualified Opportunity Zones. 

This article provides a brief overview of federal income tax benefits of 1031 exchanges versus investments in Qualified Opportunity Zones to give potential investors a better understanding of the benefits and drawbacks of both strategies.

Example: Taxpayer has owned rental real property for 10 years. Taxpayer’s current basis in the property is $1 million.  Taxpayer receives an offer to sell his property in January 2027 for $10 million.  Absent any tax planning, Taxpayer will recognize $9 million in capital gain on the sale of this asset, which could generate approximately $1.8 million in federal income tax liability. (This amount will be increased to the extent Taxpayer has any depreciation recapture with respect to this property.)   

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What is a 1031 exchange? 

A 1031 exchange (also referred to as a “like-kind exchange”) allows taxpayers to exchange their real property for similar real property without triggering the recognition of capital gain. 1031 exchanges have been a popular choice for real estate professionals looking to exchange one or more properties in their existing portfolio for new real estate investments to defer recognition of capital gain tax. 

In a 1031 exchange, a taxpayer will sell its real property that has been held for investment purposes, or for use in the taxpayer’s trade or business, (the “Relinquished Property”) and will immediately reinvest the sales proceeds into the purchase of like-kind real property (the “Replacement Property”).  If structured correctly, the taxpayer will be able to defer the recognition any capital gain that would have otherwise been recognized on the sale of its Relinquished Property. 

However, the taxable gain in a 1031 exchange is not eliminated entirely. The gain is only deferred. The taxpayer’s prior basis in the Relinquished Property carries over to the taxpayer’s Replacement Property.  Thus, when the taxpayer ultimately sells the Replacement Property in taxable sale, the previously deferred gain will be recognized, unless the taxpayer engages in another 1031 exchange.

Example of 1031 Exchange: Assume the same facts as the first example, but Taxpayer decides to engage in a 1031 exchange. Taxpayer sells his rental real property for $10 million in a deferred like-kind exchange through a qualified intermediary.  Within 180 days of the sale of the rental real property, Taxpayer (through his QI) uses the full $10 million to acquire like-kind Replacement Property. 

Under this set of facts, Taxpayer does not recognize any gain on the sale of his Relinquished Property.  However, rather than receiving a $10 million cost basis in the like-kind Replacement Property, the Replacement Property takes a $1 million carryover basis from the Relinquished Property (the rental real property). If and when Taxpayer sells the Replacement Property in a taxable sale, the gain from the sale will be calculated using the carryover basis.  

Benefits of a 1031 Exchange

• No Time Limit on Deferral. One of the biggest benefits of 1031 exchanges is that there is no time limit on the gain deferral.  Once a taxpayer has acquired Replacement Property through an exchange, the deferred gain will remain dormant unless and until the Replacement Property is ultimately sold. (If the taxpayer continues to hold the real property until death, the basis step up can potentially eliminate the prior deferred gain for his or her heirs.) 
• Multiple Exchanges.  Another significant benefit of using a 1031 exchange is that there are no caps on how many exchanges a taxpayer can engage in.  Assuming all of the requirements of a 1031 exchange are otherwise met, a taxpayer can continue to exchange real property through successive exchanges over their lifetime without triggering the deferred gain.
• Clear Rules.  1031 exchanges have been part of the federal income tax law since 1921.  While the mechanics of 1031 exchanges have been refined and modified over the past 100 years, the general requirements of an exchange are well known throughout the real estate industry.  Because the rules are clear, most taxpayers can confidently enter into an exchange without too much worry that the exchange may not be respected by the Internal Revenue Service. 

Drawbacks of a 1031 Exchange

• Real Property Only.  In 2017, Congress limited the application of 1031 exchanges to exchanges of real property.  Specifically, only real property that has been held for investment, or used in a taxpayer’s trade or business, can qualify for a 1031 exchange.  Gains from the sale of personal property like machinery, equipment or vehicles are no longer eligible for deferral.  Additionally, any gain from real property that is used by the taxpayer for his or her personal use, such as the taxpayer’s primary residence, cannot qualify for a 1031 exchange. 
• Full Reinvestment.  In order for a taxpayer to fully defer the recognition of capital gain in a 1031 exchange, the taxpayer must reinvest all of the net proceeds from the sale of their Relinquished Property into one or more Replacement Properties. The taxpayer is also required to replace the value of any debt they had on the relinquished property with new debt or additional cash. Any cash that is received by the taxpayer in connection with the sale of their Relinquished Property will be subject to tax.
• Basis.  As noted above, the basis of the Relinquished Property carries over to the Replacement Property in a 1031 exchange.  Generally speaking, this means that any built-in gain that was deferred in connection with the 1031 exchange will be recognized as soon as the Replacement Property is sold.  Further, a carryover basis will typically impact a taxpayer’s ability to take depreciation deductions (including bonus depreciation) with respect to the Replacement Property.  This often comes as a shock to taxpayers that expect to be able to depreciate components of their Replacement Property as if they were purchased outside of a 1031 exchange. 

What is a Qualified Opportunity Zone investment?

Qualified Opportunity Zones were first introduced as part of the Tax Cuts and Jobs Act of 2017 as a way to encourage investment in economically disadvantaged communities.  The program allows taxpayers to defer the recognition of capital gain if that gain is subsequently invested in a Qualified Opportunity Fund.  While the program was initially set to expire on Dec. 31, 2026, the OBBBA made the QOZ program permanent and increased the tax benefits starting on Jan. 1, 2027, making the program more attractive to potential investors. (The discussion herein focuses on investments made under the new QOZ regime starting on Jan. 1, 2027.)

Under the new QOZ program, a taxpayer that sells a capital asset can defer recognizing taxable gain if the amount that gain is reinvested into a QOF within 180 days.  The taxpayer can defer recognizing such gain until the earlier of (i) the date the taxpayer disposes of its interest in the QOF, or (ii) the fifth anniversary of the investment date. 

On the date of the investment, the taxpayer’s basis in its QOZ investment is generally zero.  However, if the investment in the QOF is held for five years, the taxpayer’s basis is increased by 10 percent of the previously deferred gain.  The taxpayer’s basis increases to 30 percent if the taxpayer has invested in a Qualified Rural Opportunity Fund, which is a fund that invests primarily in rural areas. (Defined as any area other than (1) a city or town with a population of greater than 50,000, and (2) an urbanized area adjacent to a city or town with a population in excess of 50,000.)

 Additionally, if a taxpayer holds its interest in the QOF for at least 10 years, but not more than 30 years, the basis of such investment in the QOF will be increased to fair market value on date the investment in the QOF is sold or exchanged.  Therefore, no additional gain will be recognized when the taxpayer disposes of its interest in the QOF (other than the gain recognized in year 5).  If an investor holds its QOF investment for 30 years or more, the basis of such investment will be increased to the fair market value as of the 30th anniversary of the investment on date the investment is sold or exchanged.  Essentially, if the taxpayer holds in investment for a period of 10 to 30 years, the taxpayer will have eliminated all of its capital gain exposure, other than the gain recognized in year 5. 

Example of QOZ Investment: Assume the same facts as the first example, but Taxpayer decides to invest in a QOF. In January 2027, Taxpayer sells its rental real property for $10 million, which triggers $9 million of capital gain. Within 180 days of the sale of the rental real property, Taxpayer reinvests the $9 million into a QOF. Accordingly, Taxpayer does not recognize any gain on the sale of the rental real property in January 2027.  Taxpayer’s basis in its QOF investment is $0. 

In January 2032, Taxpayer still has his $9 million investment in the QOF.  On the fifth anniversary of his investment in the QOF, the Taxpayer’s basis in Taxpayer’s investment in the QOF is increased to $900,000 (10 percent of his original $9 million gain). On this same day, Taxpayer recognizes deferred gain of $8.1 million ($9 million of his original gain, less the $900,000 increased basis) and will pay capital gains on the $8.1 million. If Taxpayer invested in a QORF, Taxpayer’s basis would have been increased to $2.7 million (30 percent of his $9 million gain), and Taxpayer would have recognized only $6.3 million of Taxpayer’s previously deferred gain ($9 million original gain, less the $2.7 million increased basis). 

Taxpayer continues to hold his investment in the QOF for another five years, and subsequently sells the investment in the QOF for $15 million.  Because Taxpayer held the investment in the QOF for 10 years, Taxpayer does not recognize any additional gain in the year of sale. 

Benefits of QOZ investment

• Any Capital Gain.  One of the biggest benefits of the QOZ program is that the rules generally allow for the investment of any capital gain, not just gain from real property.  Sale of appreciated stock, for example, can trigger gain that can be deferred through a QOF investment.  This makes the QOZ program an attractive option for non-real estate investors. 
• Only Gain Reinvested.  Unlike 1031 exchanges, which require investment of all proceeds from the sale Relinquished Property, only the amount of gain to be deferred needs to be invested in the QOF.  This means that a taxpayer may be able to keep a portion of the proceeds from the sale of their capital asset while still qualifying for full gain deferral. 
• Basis Adjustments.  As noted above, a significant benefit of investing in a QOZ relates to basis adjustment.  If the investment is held for at least 5 years, the taxpayer can completely eliminate 10 percent of their previously deferred gain (or 30 percent in the case of a QORF).  If the investment is held for more than 10 years but less than 30 years, any additional appreciation will also be tax-free.  Therefore, the QOZ program is a great option for a taxpayer looking to invest long-term. 

Drawbacks of QOZ Investment

• 5 Year Deferral Only.  The main drawback of the QOZ program is that the initial gain deferral cannot exceed 5 years.  On the fifth anniversary of the investment, the taxpayer will have to recognize their previously deferred gain, less their increased basis. Because this gain recognition event is not triggered by a sale or exchange, it will typically not be tied to a transaction that generates cash for the taxpayer.  Therefore, QOZ investors must be prepared to pay their deferred gain with cash from other sources.  This can create an issue for taxpayers that do not plan accordingly.  
• Strict Requirements for QOF.  While the non-tax considerations related to the QOZ program are outside the scope of this article, it must be noted that the QOZ rules are quite strict when it comes to operations and investments of a QOF.  For example, in order to qualify as a QOF, the fund must be actively investing in qualified opportunity zone property, and must continually demonstrate that 90 percent of its assets consist of QOZPs.  Failure to comply with this, and other reporting requirements, can trigger significant penalties for the QOF.  Thus, potential investors should be mindful when investing in a QOF that compliance with non-tax rules and regulations are necessary to achieve the anticipated tax benefits from a QOZ investment. 

Which strategy is right for me?

There is no one-size-fits-all strategy for deferring capital gain, and there are pros and cons to both 1031 exchanges and QOZ investments.  Whether a 1031 exchange or a QOZ investment is the better fit for a particular taxpayer will depend on their particular circumstances and their long-term goals.

Laura Cable is a tax attorney and partner at Cox, Castle & Nicholson. Stephen Li is a transactional attorney and partner at  Cox, Castle & Nicholson.