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One of the biggest challenges that investors in assets such as stocks, businesses, and real estate face is how to sell and reinvest, without triggering a significant capital gains tax liability.
While traditional 1031 tax-deferred exchanges are a popular strategy for commercial real estate, it can often be hard to find a suitable replacement property, especially within an exchange’s limited time frame. Investors in the stock market face even more of a challenge. Since April 2009, the S&P 500 Index has increased by over 380% (as of July 9, 2020). Investors who want to sell today face an oversized tax bill because 1031s can only be used with real property.
That’s likely one reason why so much capital from asset sales of all types has been flowing into Opportunity Zone (OZ) investments this year. In fact, investors raised more than $10 billion in equity for Qualified Opportunity Funds (QOFs) to date, with over $4 billion raised since the beginning of the year alone.
In this article, we’ll discuss everything you need to know about Opportunity Zones, and the investment incentives and tax benefits they can provide every investor.
What are opportunity zones?
The Tax Cuts and Jobs Act (TCJA) passed by Congress in December 2017 created numerous incentives for businesses and investors, including the Qualified Opportunity Zone (QOZ) program. The program aims to motivate investment and economic growth in lower-income areas in the United States and US territories such as Puerto Rico and the Virgin Islands.
- Generate economic growth with long-term investments distressed areas, including low-income urban areas, rural communities, and attractive neighborhoods adjacent to distressed areas
- Over 15% of the US population lives in a distressed area, allowing QOZ investors to help with job creation and small, community-based businesses
- QOF investments include assets such as infrastructure and industrial projects, and workforce and multifamily housing
- Profits from the sale of an asset that invest in a Qualified Opportunity Fund (QOF) within 180 days from the date of the transaction have capital gains taxes fully deferred through December 31, 2026
- Capital gains taxes owed are reduced by 10% if the QOF investment is held for at least five years up to and including year-end 2026
- Gains from investments held in a QOF for at least ten years are excluded from the capital gains tax
What is a Qualified Opportunity Fund (QOF)?
For most investors, investing in a Qualified Opportunity Fund is the easiest way to participate in a Qualified Opportunity Zone property. The IRS defines a QOF as an investment vehicle filing a partnership or corporate federal income tax return organized to invest in a QOZ property:
- QOF must be certified by the US Treasury or self-certified according to IRS guidelines
- 90% of the assets of a QOF must belong in a specified QOZ
- Three main types of QOF assets are business property such as real estate, stock of companies located in a QOZ, and a partnership interest in a business located in a QOZ
How were opportunity zones selected?
The IRS lists more than 8,760 Qualified Opportunity Zones in all 50 states, the District of Columbia, and United States Territories. Along with the mayor of Washington, D.C., governors of each state and territory nominated census tracts that the US Department of Treasury officially designated as OZs.
Regulations require a census tract to meet the following criteria to qualify as an Opportunity Zone:
- A poverty rate of 20% or more
- Median family income of no more than 80% of the statewide median family income for rural areas
- Median family income of no more than 80% of the statewide or metropolitan median family income for urban areas
Adjacent census tracts also qualify
Not all Opportunity Zones are located in low-income areas. The IRS also allows a census tract to be eligible as an OZ if it is contiguous to another tract and has a median family income of no more than 125% of the median family income in the neighboring QOZ.
Who is investing in opportunity zones?
Although deferring capital gains tax isn’t a requirement for investing in an Opportunity Zone, it’s one of the top advantages.
Investors with a long-term investment horizon who have gains from any asset – including stocks and bonds, precious metals, cryptocurrencies, artwork, and real estate – receive benefits right away and over the next several years:
- Deferred capital gains taxes due are reduced by 10% and are not payable until the 2027 tax year
- Additional capital gains from OZ investments are tax-free, provided they remain held for at least ten years
- Qualified Opportunity Funds may offer risk-adjusted returns due to preferential tax treatment and incentives, along with the potential for asset growth over the holding period
- They’re an attractive alternative for 1031 exchange real estate investors by providing a full 180 days to identify and invest in properties, compared to the 45-day identification period rule of a traditional tax-deferred exchange
- Only the capital gains portion from a sale needs to be invested in an Opportunity Zone, versus all of the net proceeds when conducting a 1031 exchange
How to invest in opportunity zones
Earlier this year, the White House Opportunity and Revitalization Council presented the Opportunity Zones Best Practices Report to the President. Some of the best practices for investing in Opportunity Zones highlighted in the report include:
- Local governments are in the best position to understand the unique strengths and needs of their communities. For example, Charleston, South Carolina, has created local rules to allow unlimited density and lower parking requirements for affordable housing in Opportunity Zones.
- States such as Louisiana adopted legislation providing up to a 10-year abatement of property taxes on renovations and improvements of existing commercial and owner-occupied structures.
- Qualified Opportunity Funds have begun focusing on affordable housing, such as a multifamily mixed-use project in Seattle the ensures 20% of the nearly 300 apartments are reserved for workforce housing
Positive impact of opportunity zone investments
OZs have received some criticism as another way to make the wealthy wealthier. However, as Bloomberg Tax notes, Opportunity Zone investments also create significant opportunities for nonprofits, economic development organizations, and local and state governments to make their neighborhoods a much better place for residents, businesses, and investors:
- Affordable housing becomes more feasible due to a lower cost of capital through tax-advantaged QOZ dollars
- Investing in existing businesses helps expansion to underserved parts of the local community
- QOFs can be designed to form new companies and scale up existing ones that agree to local their headquarters in a QOZ, helping create new jobs and higher economic growth