Investors looking to defer, reduce or exclude capital gains have various options for investing in real estate. Understanding the differences between each investment vehicle is imperative to developing an investment strategy that will help you strive to meet your financial objectives. To help provide direction, we have outlined the tax differences in investing in a Qualified Opportunity Fund (QOF), a Delaware Statutory Trust (DST) and a 1031 exchange—three of the most common investments relied upon today.
QOFs and 1031 exchanges are some of the best-known investment options for deferring taxes. At first glance, it seems as though the tax benefits associated with investing in a QOF are similar to those realized when reinvesting through a 1031 exchange. Notable differences, however, do exist.
• Only proceeds from the sale of real estate can be rolled into a 1031 exchange, while capital gains from other assets, including stocks, bonds and business equipment, can be reinvested into a QOF.
• QOF investors are not required to identify a replacement property within 45 days or use a qualified intermediary. Instead, they are given 180 days to reinvest the proceeds from the sale of their prior assets.
• To be eligible for a full 1031 exchange tax deferral, investors must invest the value (equity and debt) of their investment realized upon sale. When investing in a QOF, only gains must be invested.
Another popular way to potentially defer paying capital gains tax on the sale of real estate is by reinvesting the proceeds from the sale of the asset into a DST. DSTs are eligible for the same tax benefits as 1031 exchanges, which means investors can use DSTs as a vehicle for deferring capital gains tax, sometimes indefinitely.
Compared to QOFs, DSTs have similar tax benefits; however, investors should be aware of some differences between the two investment vehicles.
• Investments in QOFs are intended for ground-up and value-add real estate. DSTs are typically stabilized, cashflow-generating properties.
QOF capital gains deferred through 2026 are eligible for a partial step-up; they must be held for at least 10 years to be excluded. DST investments are not eligible for exclusion but may be deferred indefinitely. The asset basis is stepped up to fair market value at the time of the investor’s death.
• Only proceeds from real property may be reinvested in a DST, whereas the short- and long-term gains on the sale of nearly all assets can be reinvested in a QOF.
• QOF investments have strict geographic boundaries; DST investments have none.
• DSTs must identify a property or portfolio of properties before accepting investments, while QOFs have a “blind pool,” meaning that capital deployment is flexible if 90% of assets remain in a Qualified Opportunity Zone (QOZ).
QOFs, 1031 exchanges and DSTs all have their pros and cons. So, when determining which investment vehicle may be best for you, consider the following.
• How much authority do you want to have over how funds are invested? With a QOF, investors are often unaware of how their capital will be invested; however, in a 1031 exchange or DST, assets have already been identified.
• Is a step-up in basis important to your legacy planning? When an investor passes away, any investment made in a QOF will not receive a step-up in basis to market value; therefore, heirs will pay the tax consequence upon selling ownership in the QOF.
• Has the asset you are planning to sell already been depreciated? Unlike 1031 exchanges and DSTs, QOFs do not allow you to defer depreciation recapture on the underlying asset upon sale.
No matter your investment strategy, whether it is in a DST, QOF or 1031 exchange, or whether your investment is leveraged or not, risk is always involved. There is no guarantee that your goals will be met, and investors are always at risk of losing some, if not all, of their cash flow or investment.
The income stream, the depreciation schedule, the investment itself or a change in the tax code may affect an investor’s tax benefits (e.g., a change in an investor’s tax bracket resulting in immediate tax liabilities).
Furthermore, for those considering investing in a QOZ, additional risk must be considered. As newer investments, most have little or no operating statements; returns and gains aren’t generally seen until the property is sold or refinanced; liquidity is limited; valuation of assets can be difficult; and as unregistered securities, the regulatory protections of the Investment Company Act of 1940 are not available.
Additionally, QOZs require speculative development of ground-up or heavy value-add projects in economically distressed areas. Opportunistic real estate deals such as these can be riskier than investing in a potentially stable, cash-flowing asset through a DST. Moreover, investors are always required to invest pledged capital, no matter the performance of the asset.
The differences between these investment options can create uncertainty, even with a seasoned investor. Therefore, it is highly recommended that investors considering investments in real estate or alternative real estate funds speak with a qualified professional.
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