The Qualified Opportunity Zone (QOZ) program encourages investment to spur economic growth in low-income areas in the U.S. by offering significant tax benefits to real estate investors. Eight years ago, Julie purchased a small apartment building in her hometown. The property was priced right when she bought it, and over the years generated a nice healthy cash flow and – to her pleasant surprise – has nearly doubled in value.
She’s built up a lot of equity in the building and figures that now might be a good time to sell, when the market is so strong. But the problem is paying capital gains tax. Julie knows she can use a 1031 Exchange to defer capital gains (she did that when she purchased her apartment building) but she is concerned about finding a like-kind replacement especially while multifamily cap rates are at historic lows.
Julie wants to stay invested in real estate, but hopefully in a less hands-on role than she has had with her previous apartments. She begins researching alternative real estate investments and discovers the Qualified Opportunity Zone program. The more she learns about opportunity zone investing, the more she likes what she sees.
What are Opportunity Zones?
The Tax Cuts and Jobs Act passed by Congress in 2017 created the Qualified Opportunity Zone (QOZ) program. The program encourages investment to spur economic growth in low-income areas in the U.S. and its territories by offering significant tax benefits to real estate investors.
By investing realized capital gains in QOZs real estate investors can reduce their existing capital gains tax liability. Better still, investors can completely eliminate all capital gains tax liability from future value appreciation on Qualified Opportunity Zone investments.
These investment tax incentives give investors the opportunity to nearly double their after-tax returns when compared to a traditional real estate investment.
Tax benefits of investing in Opportunity Zones
Deferring existing capital gains taxes and potentially avoiding new capital gains taxes attracted Julie to opportunity zone investing. She discovered two key tax benefits of investing her capital gains into a Qualified Opportunity Zone:
- Realized capital gains invested in an Opportunity Fund are reduced by 10% in five years, and another 5% in seven years, and can be deferred up to nine years.
- Future capital gains on Opportunity Fund investments held in the Fund at least 10 years are completely excluded from capital gains taxation.
What are other benefits of Opportunity Zone investing?
- Capital gains only need to be reinvested, not the entire proceeds from a previous asset sale.
- Capital gains can be deferred from sales made outside of QOZs, not only from within.
- Any type of capital gain – stocks, Bitcoin, precious metals, and more – qualify for Opportunity Zone investment.
- Opportunity Funds may be created by syndicators to invest in a variety of QOZ opportunities such as residential rental property.
Using Opportunity Funds to invest in Opportunity Zones
In her research, Julie noticed that the phrase Opportunity Fund kept coming up. She soon realized that Opportunity Funds are the designated investment vehicle used to invest in Qualified Opportunity Zones.
The IRS defines Qualified Opportunity Funds as U.S. partnerships or corporations set up for investing in eligible property that is located in a Qualified Opportunity Zone.
Where are Qualified Opportunity Zones located?
After the Jobs Act was passed in 2017, State Governors presented low-income census tracts as Opportunity Zones to the U.S. Treasury and IRS. About 8,700 Qualified Opportunity Zone designations were finalized in 2018.
Opportunity Zones can be found throughout all 50 U.S. states, Washington D.C., and U.S. territories like Guam, Puerto Rico, the Virgin Islands, and the Northern Mariana Islands.
As you can imagine, Julie liked the idea of deferring and permanently excluding her capital gains from taxation and having the potential of double-digit returns. The geographical diversification that Qualified Opportunity Zone investments offered her was icing on the investment cake.
Although her apartment building had done well, she sometimes worried about having so much money tied up in one asset. If the local economy ever ran into trouble , the value of her property would likely fall at the same time as Julie’s day job might be in jeopardy.
Investing her capital gains in a Qualified Opportunity Fund could help her reduce risk by diversifying across multiple geographies throughout the U.S.
An example of how to defer and exclude capital gains tax with Opportunity Zones
Armed with her new found knowledge, as any good real estate investor would, Julie did a quick analysis of how much capital gains tax she’d defer by investing her capital gains in an Opportunity Zone:
- The capital gain from selling her apartment building would be $500,000.
- By investing that $500,000 in an Opportunity Fund after five years her taxable capital gain would be reduced by 10% to $450,000.
- After seven years her taxable gain would be reduced by another 5% to $425,000.
- The reduced deferred capital gains tax on her initial investment of $500,000 would have to be paid after nine years.
- After 10 years, any appreciationof her initial $500,000 invested would be completely tax free.
Julie sat back and thought for a moment.
Over the last eight years, her apartment building had doubled in value. If her capital gains invested in an Opportunity Fund also doubled in value to $1 million over the next 10 years, she’d have another $500,000 gain that would be completely tax free.
Common questions about real estate Opportunity Zone investing
Is there a time limit for investing capital gains in an Opportunity Fund?
Yes, the same time limit of 180 days that applies to 1031 Exchanges also applies to Opportunity Funds.
How are 1031 tax-deferred exchanges different from investing in an Opportunity Zone?
The biggest similarity is that 1031 exchanges and an Opportunity Zones can both defer or eliminate capital gains tax. That said, Opportunity Zone investing does not carry with it the like-kind constraint of a 1031 exchange.
Can more than the amount of capital gains be invested in an Opportunity Fund?
Yes, investors may invest more money than the amount of capital gains. In effect, the investor would be making two investments: One to defer capital gains, and the second as a regular investment unrelated to its capital gains.
How is an Opportunity Fund formed?
There are no laws limiting who can form an Opportunity Fund. Qualified Funds must:
- Be an entity organized for the purpose of investing in Qualified Opportunity Zone property
- Hold at least 90% of its property – such as stock, partnership interests, or real estate – within a QOZ
- Self-certify to the IRS using Form 8996 as an Opportunity Fund and verify that they are fulfilling the 90% asset requirement
What happens next? In January 2019 the IRS will hold a public hearing on proposed regulations for the Qualified Opportunity Zone programs, and issue further rulemaking.
The bottom line for real estate investment in Opportunity Zones
Qualified Opportunity Zones give real estate investors a new way to defer – and potentially eliminate – tax on capital gains. There are 8,700 Opportunity Zones in every state in the U.S. and its territories – including Puerto Rico and the Virgin Islands.
Qualified Opportunity Funds – or QOFs – are the designated investment vehicle used to invest in Opportunity Zones. QOFs can be corporations or partnerships and need to invest at least 90% of their holdings in one or more Opportunity Zones.
Capital gains that are generated from any asset sale – such as real estate, stocks and bonds, Bitcoin, and art – can be invested in QOFs. After five years the taxable capital gain is reduced by 10%, and after seven years the capital gain is reduced by another 5%.
After nine years, tax on the reduced capital gain amount must be paid. Best of all, any appreciation on the capital gains invested in a QOF is completely tax free!
Like any new government program there are always details to be worked out. But one thing is for certain: Opportunity Zones offer real estate investors a great way to defer existing and permanently eliminate new capital gains while investing in underserved communities across America.