Introduction:
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A Treasury Department-approved Opportunity Zone is a state-nominated neighborhood. All 50 states, D.C., and U.S. territories have Treasury-certified zones.
A taxpayer must invest the realized capital gain in a Qualified Opportunity Fund 180 days after the sale or exchange of an appreciated asset. The fund invests in QOZs.
The taxpayer may invest the return of principal and the capital gain. The opportunity Zone program allows the sale of valued assets, such as stocks, with gain, reinvested in a Qualified Opportunity Fund. No like-kind investment is required to delay the gain.
A taxpayer who gets a capital gain from a flow-through organization, such as a partnership, S-corporation, or trust/estate, has 180 days from the end of the calendar year to invest in a Qualified Opportunity Fund, regardless of when the entity itself realized its gain. Suppose a partnership business achieves a capital gain in March. In that case, each partner’s 180-day triggering date will be December 31, and each partner will have until June 28 of the following year to make their Qualified Opportunity Zone investment.
The Opportunity Zones tax incentive
The Opportunity Zones tax incentive encourages investment in poor areas. This incentive provides tax breaks to investors to encourage economic growth and employment creation in troubled towns. Low-income neighborhoods and select contiguous communities qualify as Opportunity Zones if a state, the District of Columbia, or a U.S. territory nominates them and the Treasury approves. 8,764 localities in all 50 states, D.C., and five territories were certified as Qualified Opportunity Zones (QOZs). Congress recognized low-income Puerto Rico communities as QOZs on December 22, 2017. Notices 2018-48 and 2019-42 list each QOZ. A map shows QOZ census tracts.
The Qualified Opportunity Zone (“QOZ”) program helps investors minimize taxes. As part of the 2017’s Tax Cuts and Jobs Act, the initiative was developed to stimulate long-term investment and economic growth in over 8,000 low-income and economically vulnerable U.S. towns.
Qualified Opportunity Zone funds must invest 90% of their assets in opportunity zones. By reinvesting capital gains in a Qualified Opportunity Zone fund, capital gains taxes can be postponed until 2026, and QOZ earnings are not taxed. Further, the QOZ investment doesn’t need to be a like-kind asset. Stocks, real estate, private businesses, precious metals, cryptocurrency, and art can be sold and reinvested in a QOZ.
A firm or individual can avoid paying capital gains taxes by reinvesting the earnings in a qualified opportunity fund. This is a tax deferral, not a permanent tax shield. Therefore the taxes must be paid by early December 31, 2026, or upon selling the opportunity zone investment. If QOZ is held for seven years or more, only 85% of the deferred gain from the initial investment is taxable. Investing $1,000,000 in a QOZ fund would tax only $850,000. The capital gains must be invested in a QOZ fund within 180 days.
The Qualified Opportunity Zone program reduces capital gains taxes on QOZ investments held for ten years or more, reducing investors’ tax exposure. The example below shows a potential investor’s tax burden after reinvesting gains in a QOZ fund vs. a fully taxed investment. I assumed equal gains in both scenarios for simplicity.
QOZ vs. 1031
QOZ investments delay taxes like 1031 Exchanges. Deferrals in a 1031 Exchange are only allowed on specified assets, and the proceeds must be reinvested in like-kind property. Unlike a 1031 Exchange, just the prior investment’s gain must be rolled into QOZ.
If you bought an item for $400,000 five years ago and sold it for $1,000,000 today, you need only reinvest the $600,000 gain into a QOZ fund to qualify for tax benefits. For a 1031 exchange, the entire $1 million must be invested in a like-kind asset. Deferred taxes on a QOZ fund gain must be paid in 2026, albeit at a lower rate, while a 1031 exchange defers taxes indefinitely.
To obtain the QOZ tax benefits, two types of investments can be made;
Real Estate:
Only properties located within a QOZ are eligible for QOZ investments. Furthermore, a real estate investment must include major property improvement. Buying and holding stabilized commercial real estate would not be sufficient. A building is considered considerably upgraded if an amount more than or equal to its adjusted basis (excluding land) is invested in rehabilitation. If an investor paid $100,000 for an existing structure on land entirely within a QOZ, they would need an additional $100,000 to invest in property upgrades to qualify for the Qualified Opportunity Zone program’s tax incentives.
Operating Business:
Investments in operational firms often qualify for tax breaks if they meet both of the following requirements. In a QOZ, the company must own or lease at least 70% of its tangible property. The company must also produce more than half its gross income through an active business activity that involves a significant component of its intangible property. In other words, unless the business model fits the above-mentioned real estate standards, it cannot rely on rental revenue for most of its income. Retail stores, restaurants, technological start-ups, warehousing enterprises, and manufacturing businesses are qualifying operational businesses.
Opportunity Zone Investment Risks
Steven Mnuchin, U.S. Treasury Secretary, estimates that the QOZ initiative will draw over $100 billion in unrealized capital gains held privately in the U.S. QOZ fund investors should consider these risks.
Ground-up construction and major rehabs are high-risk. They require large upfront investments with no cash inflows for years during building. Many QOZ locations are in unproven areas, so investors disregard them. Quality sites are scarce.
The Qualified Opportunity Zone program offers investors strong tax incentives, but investments should deliver reasonable returns before tax benefits to reduce risk. Investing only to reduce taxes is risky. This tax program doesn’t change real estate’s fundamentals. Thus your top criteria should be investment viability and QOZ fund management quality. If you can’t handle them, pay your taxes or use an alternative tax-saving program.
A QOF is a partnership that invests in QOZ land. An eligible corporation or partnership self-certifies by completing Form 8996 with its federal tax return (including extensions).
A QOF must hold at least 90% of its assets in qualified opportunity zone property on two annual testing dates or pay a monthly penalty. The eligible entity that opted or is electing to be a QOF must file Form 8996 yearly with their timely filed federal tax return (including extensions) to indicate that the QOF meets the 90% investment threshold or to figure the penalty if it doesn’t. Even in years with no taxable income, this is essential—instructions for Form 8996. A QOF is an LLC that elects to be taxed as a partnership or corporation.
Qualified Opportunity Zone Property
QOZ property is a QOF’s qualifying ownership position in a corporation or partnership that conducts a QOZ business or specific tangible property used in the QOZ. For a corporation or partnership to qualify. The interest must be acquired solely after December 31, 2017, for cash, and the company or partnership must be a QOZ business for 90% of the holding period.
Qualified Opportunity Zone Business
A Qualified Opportunity Zone business must have 50% of its total income in a Qualified Opportunity Zone each year. A business may use three safe harbors to pass these criteria. These safe ports consider:
At least half of the business’s aggregate service hours were done in a QOZ; At least half of the business’s aggregate service payments were for QOZ services; Whether income-generating tangibles and business functions were in a QOZ.
The taxpayer can still get the basis increase after five or seven years. The taxpayer’s gain for 2026 (or the year of divesting from the fund) will be the lesser of the original deferred gain or the fair market value of the fund interest less the taxpayer’s adjusted basis in the fund if any. Due to the complexity of these investments and restrictions, consult a tax professional before investing.
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