Opportunity areas are identified by the IRS as communities in need of economic development and revitalization. Through tax incentives and investment in these underdeveloped areas, Opportunity Zones have been incorporated into the Tax Cuts and Jobs Act 2017 and can boast of being one of few pieces of legislation to have received bipartisan support. The legislation helps promote community development, an increased tax base and job creation in more than 8,000 designated regions in the United States.
The U.S. Department of Treasury further classifies these communities as Qualified Opportunity Zones (QOZs), the development of which provides various tax benefits to investors who invest in Qualified Opportunity Funds (QOFs).
In this article, I will discuss who can invest in QOFs and why these funds may be a viable tax and investment strategy for some investors.
Who can invest in an opportunity fund and what benefits do they offer?
You can locate many places classified as Opportunity Zones on an interactive map on the US Department of Housing and Urban Development website. Just over 23% of opportunity areas are in rural areas. Some of the Opportunity Areas may be economically degraded, while others may simply lack goods and services due to their rural nature. Still others may be experiencing a high level of market transition and gentrification and may be ripe for development.
Qualified Opportunity Funds are key to understanding who can invest in Opportunity Zones. A qualified opportunity fund is an investment entity, such as a corporation or partnership, created to invest in Opportunity Zone investments. Many taxpayers are eligible to invest in Opportunity Zones, but only accredited investors can invest in most qualified Opportunity Funds.
Most QOFs are securities investments registered with the Securities and Exchange Commission and generally offered through investment advisers or broker-dealers. To qualify as accredited investors, a married couple must have earned at least $300,000 in the past two years and reasonably expect that income to continue, or have a net worth of at least $1 million. dollars outside of their primary residence. Additional details can be found on the SEC website.
Tax benefits associated with Opportunity Zones include capital gains tax deferral and tax-exempt investment gains if held for a 10-year period. Many investors, CPAs, and business owners believe that QOFs and Opportunity Zones can provide a great mix of tax and wealth-building strategies.
An investor can invest some or all of any capital gain from the sale or exchange of an asset in a QOF and benefit from a tax deferral on the gain. The QOF in turn invests in real estate or qualified Opportunity Zone businesses. Currently, tax on the capital gain invested can be deferred until tax year 2026, which for most investors would be payable in 2027.
Unlike 1031 exchanges, investing in QOFs does not require exchanging “like-kind” properties to qualify for deferred gains treatment. No 1031 exchange is required, and the type of gains that can be deferred in QOFs can be any type of capital gain, long or short term. The gain could include gains from the sale of stocks, cryptocurrency, private businesses, art collections, livestock, oil, or any gain that would be recognized as a capital gain. Any capital gain is eligible for a QOF (long or short term gain), and it is important to know that most QOF funds focus on real estate development as the underlying investment.
How Qualified Opportunity Funds Can Benefit Investors
In most cases, capital gains tax can be deferred by investing in a qualified opportunity fund within 180 days of the sale of the asset (sometimes longer if certain conditions are met). Deferred capital gains are not taxed by the IRS until the investor sells or exchanges the QOF interest or until December 31, 2026, whichever comes first.
Consider the case of an investor who sells a commercial property for $4 million and has a base of $2 million and $2 million in capital gains. Based on a 20% capital gains tax rate, they are subject to $400,000 in capital gains tax. Investing the $2 million in capital gains in a qualified opportunity fund allows them to keep the working $400,000 in a QOF investment for up to five years.
Also, unlike a 1031 exchange, which requires all proceeds from a sale to be invested for full tax deferral, a QOF investor can only invest their capital gains in a QOF and can do what they wants with its base. This flexibility over a 1031 exchange can provide a huge advantage to a real estate investor who may have another goal for their base and whose earnings come entirely from a real estate sale.
Potentially no tax on investment gains
Investors who maintain their QOF investments for a full 10 years will receive 100% of their investment gains tax-free provided their fund complies with IRS rules and regulations.
Investor Risks with Opportunity Zone Investments
While Qualified Opportunity Zones can offer significant tax benefits, they are also associated with certain risks, including development risks such as delays, cost overruns, utility complications, and other risks common to real estate in general.
Additionally, investing in communities in transition may involve other risks, including the continued positive trend of the community in question. Promoters must feel that the investment project can be justified independently of any tax advantage. In other words, tax benefits won’t make a bad deal a good deal, but they have the potential to make a good deal. A potential investor should carefully read the private placement offering memorandum, which describes all of these risks.
Some states don’t follow QOZ’s tax benefits to the letter, which means that QOZ can shelter federal tax, but not state tax, which is the case in North Carolina, Mississippi, and California. Despite non-compliance at the state level, federal tax benefits still apply. This means that you can still invest in a QOZ fund if you live in one of the states mentioned above, but you must be prepared to pay capital gains tax in your state.
An investor would be wise to work with a qualified financial and tax advisor to assess whether it makes sense to pay their capital gains tax now or to defer it for up to five years by taking advantage of investing in a zone fund of qualified opportunity. In a side-by-side chart, a good investment and tax team should be able to model the pros and cons for you while evaluating the investment opportunity and the information in the private placement memorandum.
Chief Investment Strategist, Provident Wealth Advisors
Daniel Goodwin is Chief Investment Strategist and Founder of Provident Wealth Advisors, Goodwin Financial Group and Provident1031.com, a division of Provident Wealth. Daniel holds a Series 65 Securities license as well as a Texas Insurance license. Daniel is a representative investment advisor and trustee for corporate clients. Daniel has been serving families and small business owners in his community for over 25 years.
Securities offered by AAG Capital Inc., member SIPC and FINRA.