Investors can defer taxes on capital gains, or eliminate them entirely, by investing in Qualified Opportunity Zones (QOZ) through Qualified Opportunity Funds (QOF).
- Investors can defer capital gains taxes from other investments by rolling over their realized gains into a QOF.
- The deferral lasts until the investment in the QOF is sold or exchanged, or until December 31, 2026 (possibility of being extended to 2028).
- If the investment in the QOF is held for at least 5 years, there is a 10% reduction in the realized gains.
- If the investment in the QOF is held for at least 7 years, there is a 15% reduction.
- If the investment in the QOF is held for at least 10 years, there is a 100% reduction.
- Only capital gains can be invested into a QOF, ordinary income is not allowed to be invested.
Created by the Tax Cuts and Jobs Act on December 22, 2017, Qualified Opportunity Zones (QOZ) are specific areas of land in the US that the government has designated as distressed areas that they want more real estate economic investment in.
Opportunity zones are nominated for designation by the state and certified by the Secretary of the US Treasury. There are currently over 8,000 Qualified Opportunity Zones located in all 50 states in the US, and five US possessions, including Guam, Puerto Rico, the Virgin Islands, American Samoa, and the Northern Mariana Islands.
You can view an interactive map of all opportunity zones on the US Department of Housing and Urban Development website.
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The government offers tax breaks for developers and investors to encourage investment into these areas, which lead to increased job creation, tax revenue through economic development, and a higher quality of life for residents.
How to invest in a Qualified Opportunity Zone
Investors can invest in opportunity zones through a Qualified Opportunity Fund (QOF), which are investment vehicles (in the entity of a corporation or partnership) organized to invest in opportunity zones.
Investors can choose to invest in opportunity zones either by investing in ready-made qualified opportunity zone funds offered by real estate development firms, or by creating their own qualified fund.
Only capital gains can be invested into a qualified opportunity fund
Ordinary income that you receive from your salary and interest payments from savings or certificate of deposit accounts cannot be invested into a qualified opportunity fund. The IRS and the US Treasury of Department only allow capital gains to be invested into a qualified opportunity zone.
Creating your own QOF
To create a qualified opportunity fund, a corporation or partnership (or LLC treated as a corporation or partnership) must self-certify by filing Form 8996 annually with its federal tax return.
Qualified opportunity funds can invest in real estate and businesses located within opportunity zones, and are required to invest at least 90% of their assets in designated opportunity zones in order to be eligible for tax benefits.
To qualify as an eligible investment, it must meet certain conditions, the most critical being that the investment be made into a new business or real estate property, or substantially improve an existing one. For example, qualified opportunity funds cannot make investments into existing real estate without making major improvements. It must invest at least the amount equal to the cost of the building and development must be completed within 30 months.
Investing in ready-made QOFs
Rather than establishing your own opportunity fund, you investors can choose to invest in funds already established by investment firms.
Many of the top real estate development firms offer real estate investments into qualified opportunity zones, available to accredited investors only. Many QOFs have a fund size of over $100 million, which would be out of scope for most individual investors to come up with that amount of money on their own.
How to elect your tax deferral to the IRS
Individual investors who hold any investments in QOF must file Form 8949 to elect the deferral of capital gains for the taxable year in which the gain would be recognized if it weren’t deferred, and also file Form 8997 with their federal tax returns.
What if I already filed my federal income taxes and didn’t defer tax on a gain?
If you wish to defer taxes on a realized gain, but have already filed your income taxes, you would need to file an amended return or an Administrative Adjustment Request (ARR), with a completed election on Form 8949.
Tax breaks of opportunity zones
There are two different ways investors can get tax benefits from investing in opportunity zones. The amount of time the investment is held determines the tax break received.
- If held for 5 years: 10% reduction in the deferred gain.
- If held for 7 years: 15% reduction in the deferred gain.
- If held for 10 years: 100% reduction in the deferred gain.
1. Tax deferral on realized gains from other investments
Investors can defer taxes on realized gains from other investments by rolling over the realized gains to a qualified opportunity fund within 180 days. The deferral lasts until the investment in the fund is sold or exchanged, or until December 31, 2026 (possibility of being extended to 2028).
Furthermore, if the investment in the QOF is held for at least 5 years, there is a 10% reduction in the deferred gain. And if the investment is held for at least 7 years, there is a 15% reduction.
2. Avoid taxes entirely
If investors hold their investment in the qualified opportunity fund for at least 10 years, they can avoid taxes entirely on the sale of the investment.
The disadvantages and risks of opportunity zones
While investing in opportunity zones provide attractive tax breaks to investors, it also comes with higher risk compared to more traditional investments. Here are a few risks that potential investors in this alternative asset class should be aware of.
- Lack of historical data: Opportunity zones are fairly new, created in 2017, so there is not as much historical data compared to traditional real estate investments or the stock market.
- Possibility of lower than expected returns: Because the government restricts what qualified opportunity funds can invest in, it’s possible to see lower returns than expected.
- Higher costs: Because QOFs have a lot of overhead, these expenses can be passed down to investors, leading to higher investing costs compared to traditional investments.
- High concentration in a volatile asset: Qualified opportunity funds are highly concentrated real estate investments, usually invested in one to five real estate projects.
Who should invest in opportunity zones?
The common situation where this makes sense if you’ve had a big exit that you’ve realized within 180 days. If you’re not planning on using that money yourself and want to reinvest it, it may make sense to roll it over to a qualified opportunity fund.
While opportunity zones are higher risk, investing the percentage of your portfolio allocated to alternative assets and real estate into opportunity zones allows you to take advantage of the tax benefits and get exposure to real estate investments at the same time. As with any concentrated investment into an alternative asset, it’s important to talk to investment professionals, like accountants and financial advisors, who have experience with this class of investment with their other clients.