The Ins + Outs of Investing in Qualified Opportunity Zones

Topic:  • By Michael Episcope • March 18, 2019 Views

The Ins and Outs of Investing in Qualified Opportunity Zones

The greatest tax break of our time—Qualified Opportunity Zones that could allow trillions of dollars of capital gains to be discounted, deferred or exempted from taxes—was first met with caution. And for good reason; it was created to drive investing in distressed areas. But now it seems that everyone wants to reap its benefits. With a tax deadline approaching, it’s time to take a serious look at its parameters.

Investing in a QOZ fund conveys two benefits. By reinvesting capital gains earned from a prior investment into a QOZ Fund, one can defer and likely cut the taxes on those capital gains. If the QOZ Fund by the investor is held for 10 years or more, capital gains earned from the QOZ Fund are tax exempt. Few tax breaks offer such a potent mix of immediate and long-term benefits.

Still, when QOZs were incorporated into the Tax Cuts and Jobs Act of 2017, funders had questions about structuring the deals, and investors about how to qualify. Origin Investments could move quickly to launch its Qualified Opportunity Zone Fund (QOF) in part because it had three projects meeting the requirements.

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Since then, the Internal Revenue Service has provided more answers, and Treasury Department regulations for Qualified Opportunity Funds should be finalized this spring. The emerging rules tell investors what they need to know about the Opportunity Zone tax break now and for future financial planning.

To understand the tax savings investors can reap by investing in a Qualified Opportunity Zone, it’s helpful to separate the benefits gained in the short-term when making the investment from holding the investment long-term.

The Short of It: Capital Gains Deferral

Initially, investors can roll both short-term and long-term capital gains from a prior investment into a Qualified Opportunity Zone Fund, and this allows them to defer taxes on some or all of the reinvested capital gains. The taxes can be deferred through the end of 2026. In all cases, they must first declare the gains (as usual) on Schedule D of their individual tax forms. In the same filing, they elect to take the deferral on Form 8949, which covers the disposition of capital assets. It’s possible to defer taxes from 2017, but only by filing an amended Form 1040X for the year.

To qualify for the deferral, QOZ funds must be invested in an opportunity zone within 180 days of earning those gains. For direct personal investments like the sale of a stock or REIT, the 180 days start when the trade settles. There is a special partnership rule for capital gains born from a pass-through entity owned by the investor, which can potentially defer the start of the 180-day clock until the last day of the pass-through entity’s fiscal year.

Capital must be invested by this 180-day deadline-—not simply pledged as a future commitment, as in most private equity real estate funds. To take continued advantage of the 180-day requirement, it is necessary to identify fund managers who can generate a predictable flow of QOZ deals, which can be tricky since the timing of real estate closings can be fluid and often delayed.

Taxes on the capital gains reinvested in a QOZ Fund can be deferred until the end of the 2026 tax year, or earlier if the QOF shares are sold or exchanged before then. In settling those taxes, the capital gain’s original tax attribute will be preserved throughout the deferral period. Thus, if it was a short-term capital gain, the same short-term tax treatment will apply when the deferred taxes are paid for that gain. The same applies for long-term capital gains. The reinvested capital gain is simply calculated as income for that taxpayer in the 2026 tax year. In that respect, a QOF investment may defer taxes, but not necessarily lower them.

However, another tax break is reserved for QOF assets held for five or more years by the time the end of 2026 rolls around. QOF investments held for five years qualify for a 10 percent step-up in basis of the initial deferred gain, and an additional 5 percent step-up in basis if the QOF investment has been held for at least seven years by the end of 2026. Most participants will plan for such long-term investments because then an even greater tax advantage is extended to the appreciated value of opportunity zone properties or businesses.

The Long of It: QOZs as Tax Shelters

Holding an Opportunity Zone Fund investment for at least 10 years raises the investment’s tax basis to the fair market value when sold or exchanged, and there is no capital gain incurred from the QOF investment. In other words, capital gains earned from the QOF investment are exempt from federal capital gains taxes.

This is an enduring benefit: Under proposed rules, a QOF investment can be made as late as December 31, 2026; qualify for the stepped-up tax basis after holding the investment for 10 or more years; and be eligible for the exclusion of capital gains taxes through 2047.

QOF’s can invest in companies that own real estate or businesses in QOZs, or they can own properties directly. Both types of funds qualify for the same tax advantages; funds certify to the IRS that they meet the requirements. Investors can exchange their QOF investments in much the same way as in a 1031 exchange. Longstanding tax rules allow property owners to swap properties without incurring a capital gain.

“QOFs will be viewed by many taxpayers as an attractive alternative to the 1031 exchange,” says Andrew P. Doup, an associate at the Kegler Brown law firm in Columbus, Ohio. Those who defer gains through a QOF are not limited to a like-kind exchanges but can trade up to business property, Doup writes in Urban Land magazine.

More QOZ Ins and Outs to Weigh

Ninety percent of QOF real estate assets owned directly must be located in the opportunity zones. QOZ companies have additional leeway over their assets, Doup notes. As many as 30 percent of business assets may be located outside the designated zones, as long as at least half of gross income comes from business activity in the zones. Doup suggests this may encourage fund investments in real estate companies.

Opportunity funds could raise $30 billion in capital over the next few years, Real Assets magazine suggests. But the potential investor pool is immense: the Economic Innovation Group, an early advocate of the opportunity zone concept, notes that individuals and corporations hold more than $6 trillion in unrealized capital gains eligible for reinvestment.

However, the larger issue is that it is not easy to find QOZ deals for real estate and/or businesses with good fundamentals. As with every investment, there are risks—including the potential for losses, MarketWatch notes. Not all opportunity zones will achieve the kind of turn-arounds that will yield profits for investors, and competition is fierce for deals in those zones that have more favorable fundamentals— from location to commitments from local governments and businesses. Such realities make it more important than ever for private real estate investors to do thorough due diligence on fund managers.


RELATED: Clearing the Confusion on Qualified Opportunity Zone Fund Timing


Another issue that may have slowed early adoption of opportunity funds is unclear rules: Draft regulations drew scores of public comments related to the gains that qualify the process for deferring them and the rules for how the funds value and certify their assets. As the Treasury Department responds with more guidance, and addresses potential loopholes that can defy the intent of the program, investors should feel more certain that they’ll realize the full benefit of their opportunity fund investments.

Posted By

Michael Episcope
Principal

Michael is principal of Origin, co-chairs the Investment Committee and oversees investor relations, marketing and company operations. Michael brings 25 years of investment and risk management experience to the company and believes that calculated risk-taking in inefficient markets is the key to building wealth.