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Are you interested in a Qualified Opportunity Zone and wondering who can take advantage of them? Learn about the pros and cons of Opportunity Zone investing and see if it is a sound financial decision for you or your business. Here you will find the full rundown of what Qualified Opportunity Zones are, how they work, how to invest, and the risks and rewards of Opportunity Zone investing. You will also learn how their tax incentive structures work and how one of these investments could potentially suit your needs as a real estate professional.
History, definition, and purpose
The IRS defines Qualified Opportunity Zones as economically distressed communities where new investments, under certain circumstances, may be entitled to advantageous tax treatment. A Qualified Opportunity Zone property is a property that officially meets the criteria set by the IRS. They were added to the tax code under the Trump Administration as part of the Tax Cuts and Jobs Act of 2017. This legislation made several notable tax law changes, including individual income tax, itemized deductions, marginal tax rates, and more. The purpose of Qualified Opportunity Zones is to encourage real estate investors to drive economic development in troubled areas. These investments spur economic growth in the areas that need it most.
Why would you want to invest in a Qualified Opportunity Zone?
The United States government rewards investors in these zones with tax benefits. Why are people so excited about this? Opportunity Zones investing is among the biggest opportunities in commercial real estate in 2021.
- It is imperative that to invest in a Qualified Opportunity Zone, you must invest in a Qualified Opportunity Fund (QOF).
- A QOF is an investment vehicle specifically designed to invest in Opportunity Zones across the United States.
- For a QOF to be confirmed, 90% of its investments must be in Qualified Opportunity Zones.
- Tracked by Novogradac in 2019, these funds surpassed the $15 billion mark at the end of 2020.
- Since tracking began, 659 QOFs reported their earnings to contribute to this substantial sum.
Now is a great time to get into Qualified Opportunity Funds. There is not a lot of time left between now and the December 31st deadline, which we will get to later. As December 31st approaches, you could see increased competition with new investors entering the market which might diminish your potential gains as the market becomes more saturated with activity.
Why wouldn’t you want to invest in Qualified Opportunity Zones?
With more and more people getting into Opportunity Zone investing each day, it is becoming increasingly competitive. While tax deferrals are fantastic investing incentives, if the idea of tax-free investing sounds too good to be true, that’s because it is. Deferral doesn’t mean you never pay tax. All investors who decide to get into this space must pay their capital gains tax eventually. This tax deferral is not potentially endless like that from a 1031 Exchange.
To get tax incentives, investors need to invest in a QOF. Any investor who can meet the qualifications of a QOF is eligible to invest in a Qualified Opportunity Zone, as these funds are not specifically limited to real estate professionals. Unfortunately, unlike other tax deferral strategies for real estate, Opportunity Zones investing is not necessarily geared towards the small investor. The entire purpose of these incentives is to provide cause for investors to put large amounts of resources into underfunded communities.
Investors and operators must get these details right. For a property to meet the criteria to be in a Qualified Opportunity Zone, one of two things must happen:
1). It must qualify as original use. Meaning the property must be:
- A Ground-up construction – building a structure completely from scratch.
- A Development Property – the process of developing buildings or land into a higher use-value.
- A Vacant Property – must have been unoccupied for at least three years or
empty for at least one year before incorporated but remaining vacant at purchase.
- Brownfield Land – any previously developed land that is not currently in use that may be potentially contaminated.
- A Hazardous Sites – sites with or potential presence of hazardous substances.
2). Does NOT qualify for original use and requires substantial improvements:
- Substantial improvements – investors must put at least the same sum as their original investment into their property. Excluding the value of the land. See the example below:
If you want to defer your capital gains from a prior or current investment, you can re-invest your gains into a QOF.
This is true even if that capital gains are from a business outside of real estate investing. All of this incentivizes investors to make huge improvements in areas throughout the country that need it most.
Creating a win-win situation for the communities who receive much-needed improvements and the investors who receive tax incentives.
With major economic growth in the last ten years, many investors have capital gains that they want to shield from capital gains tax. Qualified Opportunity Zones are a very mutually beneficial way to achieve this.
How do I avoid taxes on Qualified Opportunity Zones?
While taxes cannot be avoided entirely leveraging this type of investment, Opportunity Zone investing does not come without its perks. These benefits come in three distinct stages.
After five years:
- 10% of deferred capital gain is excluded from capital gains tax. For Example:
- Capital gain of $1,000,000.
- $900,000 subject to capital gains tax.
- $100,000 of that gain is tax-free.
After seven years:
- 15% of deferred capital gain is excluded from capital gains tax: Using the same example:
- Capital gain of $1,000,000.
- $850,000 subject to tax.
- $150,000 tax-free.
However, if after seven years the investment is still in the QOF, you will unfortunately still have to pay taxes on $850,000 regardless. The biggest incentive is not necessarily on the final amount excluded, but generous benefits for appreciation, or rather the lack of penalties. The investment basis in QOF is increased to fair market value on the date of sale or exchange and will essentially grow tax-free.
After Ten years:
- Similarly to the example above if the fund sells for $2,000,000, a gain of $1,000,000. You should expect:
- $850,000 tax subjectable.
- $1,150,000 tax free.
There is essentially no tax on the appreciation. This is great for you because if you’re already into a property for $3 million, you’ll know there will be some upside to your investment.
“The taxpayer may invest the return of principal as well as the recognized capital gain, but only the portion of the investment attributable to the capital gain will be eligible for the exemption from tax on further appreciation of the Opportunity Zone Investment. The Opportunity Zone program allows for the sale of any appreciated assets, such as stock, with a reinvestment of the gain into an Opportunity Zone Fund. There is no requirement to invest in a like-kind property to defer the gain.” – Wells Fargo.
Where are the Opportunity Zones in the US?
According to the Economic Development Administration (EDA), there are more than 8,760 designated Qualified Opportunity Zones (PDF) in the United States. Twelve percent of U.S. census tracts are in Opportunity Zones.
These low-income areas are throughout all 50 States, the District of Columbia, and five United States territories. States and territories can nominate communities for designation. The U.S. Department of the Treasury reviews and certifies the nominations.
In the eastern half of the country, these zones tend to be smaller and more abundant. The inverse is true in the western half of the country where they are much larger and sparser.
What are the regulations?
In December of 2019, the U.S. Treasury Department and the IRS issued final regulations implementing the Opportunity Zones tax incentive.
According to Secretary Steven T. Mnuchin, “These regulations provide clarity and certainty for investors, which will enhance the flow of capital to new and expanding businesses and create sustained economic growth in communities that have been left behind.”
These rules helped provide insight into deciding eligibility and qualifications for QOF as well as their subsidiaries, and levels of new investment. They also shed light on the types of gains that are required for Qualified Opportunity Zone investments, and the capital gains that may be excluded from tax after the 10-years.
QOFs are begun by active real estate investors through any of the following: partnerships, limited liability companies (LLC), or corporations. The asset should record the right administrative paperwork and cling to IRS guidelines. It is required that any property included as an investment be one or more of the following:
- Undeveloped, and show a huge improvement in 30 days of closing.
As indicated by the IRS, for Opportunity Zone investing you have to move money or property to a QOF. Illiquid assets may disqualify a portion of the property from eligibility. Another requirement is you must meet yearly investor standards detailing reports of the property’s condition. You must also begin your investment inside the 180 day period from when you receive your capital gain to obtain your tax benefits.
Potential future challenges
While leveraging tax reductions and helping underdeveloped neighborhoods is a mutually advantageous situation. And Qualified Opportunity Zones have many benefits there are also some challenges:
- They hold up your cash.
- To get the full break from investing in one, your investment must sit for at least five years.
- On the off chance that you need the cash immediately, pulling your cash out of the fund could mean risking losing the tax break.
Administrators of these funds should pick areas that show development and strength. This will give the asset the best possible chance of developing and the local area benefiting. For this reason, monetary specialists advise you to bring proficient local area knowledge and investing know-how to the table whenever putting resources into promising Qualified Opportunity Zones. Like any financial investment, it’s best to thoughtfully researching your QOF investment.
Tax deferral through 2026
All investments in Qualified Opportunity funds must be made before December 31, 2026.
Maintaining your investment Investing after 2021
Keeping in mind the 2026 deadline, it is worth noting that if you want your investment to be held for a five-year (so that you can qualify for the 10% tax reduction) then the end of 2021 is the latest you can invest.
What if there is a loss in value?
There is without a doubt some risk to Opportunity Zone investing. If your fund starts losing money you risk this loss overtaking the money saved through tax benefits.
“Depending on market conditions, you may not be able to sell to mitigate potential losses.” -Fidelity Investments.
This is a factor that cannot simply be ignored. Panic selling one of these funds might be an ineffective last resort.
Could Qualifies Opportunity Zones share the same fate as the 1031 Exchange? It is unlikely that you would see the elimination of incentives for QOFs. One of the foremost purposes of President Biden’s tax plan is to distribute resources to invest in infrastructure. Abandoning any attempt to improve dilapidated communities through financial improvements would go against the narrative of this plan.
If trading slows down, you could see an immediate decline or stabilization in the value of all real estate investments. If people don’t want to buy, it would become harder to sell your property.
However, with the long-term holding periods required by Qualified Opportunity Zones the value of your QOF should steadily increase as more and more people want to buy but are limited due to the current tax laws.
More realistically, you would see a leveling-off period before a decline or rise in trading.
In addition to the many rewards and benefits, and the added reward of contributing to the large improvements of communities in need. You will have to decide soon, the 2026 deadline is not very far off and to get the minimum return on your investment you’ll need to act before the end of 2021.
What else are you wondering about Qualified Opportunity Zones?
Share your questions or comments with us below!
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