Investors now have a new tool to help minimize taxes via the Qualified Opportunity Zone (“QOZ”) program. The program was created as part of the 2017 Tax Cuts and Jobs Act to spur long-term investment and economic development in over 8,000 designated low-income and economically distressed communities throughout the United States. A Qualified Opportunity Zone fund is a type of investment vehicle that is required to invest 90% or more of its assets in one or more of the designated opportunity zones.
To incentivize investors to participate in QOZs, the program allows for the deferral and elimination of certain capital gains taxes. Essentially, any tax on capital gains can be deferred until 2026 by reinvesting the gains into a Qualified Opportunity Zone fund, and the capital gain achieved from the QOZ investment itself is not subject to any taxes at all. Further, the QOZ investment does not need to be a like-kind asset from which the capital gains were achieved. Some examples of assets that can be sold and the proceeds reinvested in a QOZ are stocks, real estate, a private business, precious metals, cryptocurrencies, and art.
How the QOZ Program Works
When a company or individual sells an investment from which they realized taxable capital gains, they can defer paying the taxes by reinvesting the gains into a qualified opportunity fund. Keeping in mind that this is a tax deferral and not a permanent tax shield, the taxes still need to be paid by early December 31, 2026, or upon the disposition of the opportunity zone investment. In addition, if the QOZ investment is held for seven or more years, only 85% of the deferred gain from the prior investment would be taxable. For example, only $850,000 of a $1,000,000 gain would be taxable if invested in a QOZ fund. In order for the investment to qualify, it must be invested in a QOZ fund within 180 days of realizing the capital gains.
The Qualified Opportunity Zone program also eliminates taxes on capital gains earned from the actual QOZ investment, if held for 10 or more years, which can significantly reduce the investor’s total tax liability. The example below illustrates an investor’s hypothetical tax liability after reinvesting gains into a QOZ fund, compared to rolling them into a fully taxable investment. For simplicity, I’ve assumed the same relative amount of gains in both scenarios.
Qualified Opportunity Zones vs. 1031 Exchange
The tax deferral function of a QOZ investment is similar to that achieved by a 1031 Exchange. However, deferrals in a 1031 Exchange are only available on the sale of certain assets, and the total proceeds from such a sale must be reinvested in like-kind property. Unlike a 1031 Exchange, only the gain from the prior investment needs to be rolled into the QOZ investment.
For example, if you bought an asset five years ago for $400,000 and sold it today for $1,000,000, you would only need to reinvest the $600,000 gain into a QOZ fund to be eligible for the QOZ tax benefits. In a 1031 exchange, the entire $1 million would have to be invested in a like-kind asset to obtain its respective tax benefit. The deferred taxes on the gain rolled into a QOZ fund ultimately need to be paid in 2026, albeit at a slightly reduced rate, whereas an investor can defer taxes indefinitely in a 1031 exchange.
Eligible Qualified Opportunity Zone Investments
There are two types of investments that can be made to achieve the QOZ tax benefits;
- Real Estate: Only properties in a QOZ are eligible for QOZ investments. Additionally, an investment in real estate must involve a substantial improvement of the property. Simply buying and holding stabilized commercial real estate would not qualify. A building is considered to be substantially improved if an amount greater than or equal to the adjusted basis of the building (excluding land) is invested to rehabilitate the property. If an investor purchased an existing building on land wholly within a QOZ for $100,000, they would need to invest an additional $100,000 or more in property improvements to qualify for the tax benefits of the Qualified Opportunity Zone program.
- Operating Business: Investments in operating businesses generally qualify for the tax benefits if they meet both of the following criteria. The business must own or lease at least 70% of their tangible property in a QOZ. The business must also generate more than 50% of its gross revenue from active business conduct that involves a substantial portion of the business’s intangible property. In other words, the business model must not rely on rental revenue for the majority of its income, unless it meets the real estate requirements mentioned above. Some examples of eligible operating businesses include retail stores, restaurants, technology start-ups, warehousing businesses, and manufacturing businesses.
Inherent Risks with Qualified Opportunity Zone Investments
Steven Mnuchin, Secretary of the U.S. Treasury, has estimated that the QOZ program will attract over $100 billion of the $6 trillion in unrealized capital gains held privately in the U.S. today. Individuals interested in making QOZ fund investments should consider the following risks:
- Ground-up development projects and major real estate rehabilitations tend to be higher-risk in nature. They involve laying out significant sums of up-front capital with no cash inflows for several years while the construction is being completed.
- QOZ locations have been historically overlooked by investors because many are in unproven areas. The availability of high-quality sites is limited.
The Qualified Opportunity Zone program holds a powerful tax benefit for investors, but to mitigate risk, the investments should be able to produce viable returns before factoring in the tax benefits. Investing solely for tax reduction purposes can be a dangerous way of looking at the world. This tax program does not change the fundamentals of real estate and your most important criteria should be the viability of the investment and the quality of the QOZ fund manager. If you are unable to get comfortable with those, then paying your taxes or utilizing an alternative tax-saving program is probably the better option.
At Origin, we have carefully reviewed the viability of several QOZ real estate development opportunities and we are proceeding with a select few, which will be made available on a limited basis via the Origin QOZ Fund.