As a result of the Tax Cuts and Jobs Act of 2017, the Internal Revenue Code has been significantly revised. From the perspective of real estate investors, one of the most potentially important changes was the establishment of Qualified Opportunity Zones. Technically speaking, these Opportunity Zones aim to attract capital investment to areas with weak economies. However, they offer a fantastic chance for favorable tax treatment to real estate investors if handled appropriately.
Therefore, this paper aims to provide a general introduction to real estate investment in Opportunity Zones. More precisely, we’ll discuss the following:
- Tax Incentives and Other Benefits for Qualified Opportunity Zones
- About Qualified Opportunity Funds
- Considerations for QOF Real Estate
- Conclusion
Tax Incentives and Other Benefits for Qualified Opportunity Zones
The Internal Revenue Service defines qualified Opportunity Zones (QOZs) as “economically challenged communities” that, under certain circumstances, may be eligible for favorable tax treatment on new investments. These tax breaks are expected to increase investment in these low-income areas.
To be a Qualified Opportunity Zone (QOZ), a municipality must first be nominated as such by a state, the District of Columbia, or a U.S. territory, and then have that nomination confirmed by the Secretary of the U.S. Treasury through the Internal Revenue Service’s authority (IRS). The fifty states and the District of Columbia have all established QOZs.
Capital gains may be 1) deferred, 2) reduced, or 3) avoided depending on the QOZ’s tax status. A common practice among investors is to place the proceeds from a sale into a QOZ investment. Let’s pretend you sold some stocks for $150,000 and made a profit. The capital gains tax on investment of up to $150,000 made in a qualified opportunity zone (QOZ) that complies with IRS regulations can be postponed by filing IRS Form 8949, Sales and Other Dispositions of Capital Assets. Additionally, you can postpone paying any taxes due on the first capital gain.
And the length of time that you can defer paying taxes on those gains is directly proportional to the amount of time your money is kept invested in the QOZ. To be more specific, investors can defer paying tax on any gain amounts invested until sooner than the date they sell or exchange the [QOZ] investment or the date earlier than December 31, 2026. Put another way; you will be required to acknowledge the initial gain no later than the first of January 2027.
One’s ability to reduce their overall tax burden is influenced by how long their money remains in a Qualified Opportunity Zone investment. In technical terms, if you immediately sell your initial QOZ investment, you would be subject to capital gains tax on the full amount. However,
- Holding the [QOZ] investment for at least five years will result in a 10% growth based on the [QOZ] investment, which is the amount that can be delayed.
- The investor’s basis in the [QOZ] investment will increase to 15% of the deferred gain if the investment is held for at least seven years.
As such, investors can A) postpone paying capital gains taxes and B) lower their tax burden by up to 15 percent using QOZs. The seven-year, 15 percent rise in basis is only available to new investors until December 31, 2026, when the Opportunity Zone tax deferral regime will no longer be in effect. However, they are still eligible for A) deferral and B) the 10% basis increase over five years.
QOZ investments are most valuable because of the ability to avoid paying taxes, despite the benefits of tax deferral and reduction.
- Suppose an investor keeps their money in a Qualified Opportunity Zone (QOZ) for at least ten years. In that case, they can choose to have their basis in the investment recalculated to reflect the asset’s fair market value as of the date of sale or exchange.
We’ll give you an example to show you how useful this may be. Let’s pretend you put $100,000 in a QOZ. The first capital gains are subject to taxation, either in full or at a reduced rate, in your 2027 return. But let’s pretend you’re planning on keeping that $100,000 investment for the next decade. Once the ten years have passed, your initial investment of $100,000 will be worth $500,000. You have the option to change your investment’s basis to its sale price when you sell. If you sell your investment for $500,000, you won’t have to pay any capital gains tax.
About Qualified Opportunity Funds
If you’ve seen the potential of Opportunity Zones, you’re probably wondering: where should I put my money? The Internal Revenue Service has mandated that you make all investments in QOZs through a certain type of fund known as a Qualified Opportunity Fund (QOF).
A Qualified Opportunity Fund (QOF) is a type of investment vehicle that is created for the exclusive purpose of investing in Qualified Opportunity Zone (QOZ) property, as defined by the Internal Revenue Service (IRS). Additionally, the IRS has provided QOF guidance that considers the popularity of LLCs created at the state level. An LLC can form as a QOF if its members elect to have the company or partnership tax status for federal income tax purposes.
Establishing these types of funds is rather simple since qualified organizations can self-certify their status as QOFs by submitting Form 8996 with their yearly federal income tax returns. The Form 8996-required return must be submitted on time (including extensions). It is also possible for investors to locate pre-existing QOFs as an alternative to establishing their own. You can enjoy the tax benefits without the hassle of setting up and operating your own QOF.
Considerations for QOF Real Estate
In particular, the QOZ scheme provides extraordinary advantages to property investors. Another key benefit real estate investors enjoy is tax liability reduction. A depreciation recapture tax is usually due when an income-generating asset is sold. This tax, which is a flat 25 percent on permitted MACRS depreciation for the holding term, can drastically reduce the profitability of a transaction. After the ten-year holding term for QOF property is met, depreciation recapture will not be taxed upon sale.
However, real estate investors must meet other criteria to receive QOF treatment. Opportunity Zones are designated locations where the federal government has set aside funds specifically to help revitalize economically depressed communities. Therefore, it is in the interest of the federal government and the IRS to ensure that real estate QOFs genuinely increase the value of their holdings. Therefore, for QOFs to qualify, they must significantly upgrade any property they acquire. The Internal Revenue Service defines substantial improvement as additions to the basis of the property over any 30 months beginning after the property is acquired that exceeds an amount equal to the adjusted basis at the start of the 30 months.
You must put twice as much money into the QOF property’s upkeep as the property’s adjusted basis. If you want to take advantage of tax breaks for investing in Opportunity Zones, you can’t just buy and manage a stabilized apartment complex there.
Conclusion
Let me be clear: the information presented here only scratches the surface of Opportunity Zone investing. Our intention was not to turn you into a professional. Rather, we hope that the preceding has shown you the fantastic tax benefits of investing in a QOF, especially one that deals in real estate.
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