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Investment Trends: Qualified Opportunity Zones

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Investing in low-income Opportunity Zones offers tax incentives

The community development program, known as “Qualified Opportunity Zones,” was created by Congress as part of the Tax Cuts and Jobs Act of 2017. According to the Treasury Department, it was designed to “spur investment in distressed communities throughout the country” by offering investors tax incentives in exchange for capital investments into designated areas. Although the program went through some growing pains in 2018 and 2019 as its rules and regulations were being digested by both investors and fund managers, by 2020 investors seeking both the tax advantages and return potential of investing in Qualified Opportunity Zones had committed more than $12 billion (and as much as $75 billion) to Qualified Opportunity Funds.

The program offers compelling tax incentives for making long-term investments in low-income communities nationwide. Not only can investors defer and reduce the capital gains tax on assets sold to buy into an Opportunity Zone investment, but they can also eliminate all capital gains tax on the Opportunity Zone investment itself (subject to a mandated holding period.)  The program was enacted as part of the Internal Revenue Code, and only applies to Federal income taxes (not state income taxes).

The IRS has twice allowed additional time for QOZ investors to roll over realized gains due to the Coronavirus pandemic, the most recent announcement occurring January 19, 2021. This has created an unusual opportunity for many investors who realized a large capital gain at any time in 2020 to roll that into a QOZ investment by March 31, 2021 to defer the tax liability and secure the additional tax benefits of the QOZ plan.

 

The engine behind the legislation

map of opportunity zones

A “doing well by doing good” concept, the Opportunity Zone program was originally developed by the Economic Innovation Group, a think tank, to help address the growing economic inequality that has left many low income communities behind.

The idea was buoyed by a swell of support from a wide range of investors, entrepreneurs, community developers, economists and other stakeholders. It was then taken to Congress where it was championed by the bipartisan team of Senators who led a regionally and politically diverse coalition of nearly 100 congressional co-sponsors.

 

Selection of census tracts

Following the spirit of the program, nearly all QOZs are in census tracts with a minimum 20 percent poverty rate or a median family income below 80 percent of the statewide median or metropolitan median. But there are some surprises. For example, some tracts adjacent to New York’s Central Park and downtown Los Angeles made the list of QOZs. This gives investors who want to put their money exclusively near highly developed areas of major cities many geographic opportunities to do so.

Rules of the road

Here's how the program works as codified by the Tax Cuts and Jobs Act of 2017:

  • Sale of an asset: On the sale of an asset, including stocks, bonds, real estate or a business, the program allows investors to defer all taxes on reinvested capital gains until as late as the 2026 tax year.
  • Within 180 days following sale of asset: In order to get deferment of taxes, up to 100 percent of the capital gains proceeds (but not any amount deemed return of capital or basis) can be reinvested into a Qualified Opportunity Fund (QOF) as long as this occurs within 180 days of the sale of the asset. The QOF must then make investments into businesses or real estate projects that qualify as Opportunity Zone properties under specific requirements regarding their location and use in a QOZ.
  • To qualify for the tax benefits: A QOF must be established to make Opportunity Zone investments. A QOF may be a partnership or a corporation, but must have at least 90 percent of the fund’s total assets invested in QOZs at all times. Individuals may start their own QOF or, if qualified, invest in a comingled, professionally managed fund which may have specific net worth or income requirements.  In addition, all QOZ assets of a QOF must be new or substantially improved. Purchase of an existing business or real estate property without additional improvement is not allowed. For real estate projects, this “substantial improvement” provision requires an investment at least equal to the basis of the existing property (excluding the basis of the land). The improvement must be completed within a 30-month period.
  • Investment options: Although the Opportunity Zone program is likely to have the most potential for real estate investors, it was designed to encourage investment across a wide variety of business sectors and industries. These include operating businesses or even public-private partnerships (PPP). However, there are some restrictions on investments in so-called “sin” businesses, such as liquor stores, massage parlors, golf courses, country clubs, racetracks or casinos.
  • If reinvestment held at least 10 years: The investor pays no capital gains tax on the appreciation of the investment in the QOF when realized. And the news gets better: there is no cap on this. Even if the Opportunity Zone investment doubles in value, as long as the QOF is held for at least ten years, the taxpayer will only be liable for tax on the initial deferred gain and will owe no tax on the QOF investment when sold. It is important to note that due to the sunset provision, the tax on the initial deferred gain will be due before the QOF investment reaches the 10-year investment period.

Some tracts adjacent to New York's Central Park and downtown Los Angeles made the list of QOZs.

 

The longer the investment is held, the sweeter the tax benefits.

The following scenario illustrates what effect the length of the holding period has on capital gains taxes:

Let’s say an investor has a $1 million gain on the sale of a stock and, based on a 23.8 percent tax rate, stands to owe $238,000 in capital gains tax. But instead of paying, the investor reinvests the $1 million gain in a QOF.

 

If the QOF investment is held for 5 years: The $238,000 capital gains tax is completely deferred, plus the investor gets a 10 percent step-up in basis on the original gain. When deferment ends, only 90 percent or $214,200 is owed, saving $23,800 in capital gains taxes.

 

Taxes due on the original deferred gain will be realized subject to the 10 percent step-up (or 15 percent for QOF investments made by 12/31/2019) on the earlier of the sale of the investor’s interest in the QOF and December 31, 2026. It is important to note that the tax owed at that time will be based on the tax rates at that time (not today’s rates).

After holding the QOF investment for 10 years, we assume it is sold with zero capital gains due on the QOF investment return.

qof investment scenario comparison table

Capital Gain Tax Rate (Federal only)

QOF Investments vs. 1031 Exchange

Potential risks of investing in Opportunity Zones

Although many established asset managers are seeking to raise eligible comingled funds to offer qualified investors, one of the biggest drawbacks will be the lack of a comparable performance track record to review.

In addition, owning a business interest in a lower-income area generally brings additional risk relative to more developed areas, as these areas tend to underperform in cyclical down turns.

 

Other concerns to consider:

  • Market Conditions: This real estate cycle is getting “long in the tooth” and prices have already increased in many lower-income QOZ areas. Additionally, the uncertainties around the economic rebound post-pandemic are significant. In light of this, investors should temper return expectations on both a pre- and post-tax basis.
  • Liquidity: For real estate projects, the “substantial improvement” provision can present a liquidity risk. An investment at least equal to the basis of the existing property must be completed within a 30-month period. Also, the deferred tax will be due before the liquidation of the fund at the tax rate applicable at that time, which could be higher than current rates.
  • Uncertainty: Although initial support for the Opportunity Zone program in Congress was strong, there is a risk that a new administration or future legislation could change the rules and benefits.

 

Conclusion

Under the right circumstances, the compelling tax benefits of Opportunity Zone investments could be worth consideration. Be reminded that there are strict time limits for this program: after the sale of an asset, you only have 180 days to reinvest the capital gain into an QOF. In addition, per the current legislation, the ability to defer and reduce capital gains will sunset on December 31, 2026. This means that, in order to receive the 5-year hold basis step-up, you must reinvest by December 31, 2021.

Final regulations were published by the Office of the Federal Register on December 19, 2019. For the latest information on this topic, visit the U.S. Department of the Treasury or the Internal Revenue Service.

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