If you’re an accredited investor, you’ve probably heard about Qualified Opportunity Zones (“QOZ”). Here’s a short guide to outline the what’s, why’s and who might consider this investment strategy.
What opportunities and challenges do QOZs address?
Opportunity zones were created to spur economic development in distressed communities across the nation by the Tax Cuts and JOBS Act on December 22, 2017. What do these areas look like? For the most part, they are urban areas with high unemployment, significantly higher minority populations than the rest of the country, low median family incomes, have an average poverty rate of 30%, and 38% of prime age adults are not working.
To qualify as a QOZ, it had to meet a second requirement. The zone had to exhibit the potential for revitalization to qualify. By measuring growth in the number of businesses post the Great Recession (between 2011 and 2015) and corresponding employment growth, most did witness growth, suggesting that the program might stimulate further and accelerated growth. There are now 8700 QOZs in states, territories and Washington D.C. Critics raise the specter that this may lead to “gentrification,” negatively affecting the more disadvantaged within the QOZs, but it is too early to determine whether this will be the result.
By rewriting the tax code, the government hopes to draw investors to the QOZs through a series of tax benefits that are tied to the length of their investment in these zones. The opportunity is enormous: In 2017 alone, $6.1 trillion in capital gains were generated.
What’s in it for you? How has the government made these investments enticing? It’s pretty simple:
- Defer Capital Gains: You can defer tax on any prior capital gains invested in a “Qualified Opportunity Fund” (QOF) or directly (by purchasing property in a QOZ) until the earlier of when the investment is sold or exchanged or December 31, 2026.
- Reduce Capital Gains: If the investment is held for 5 years, you receive a 10% exclusion of the deferred gain. If the original investment is held for seven years or longer, the 10% rises to 15%.
- No Taxable Gains: Finally, if held for 10 years or more (but no later than December 31, 2047), you are eligible for an increase in basis equal to the investment’s fair market value on the date that the investment is sold or exchanged.
So, what does that mean? Think of your tax returns. Did you sell any stock for a capital gain? If so, to defer paying capital gains, you have 180 days from the date of that sale to invest some or all the amount of the gain in a QOZ to take advantage of this program. (Sound familiar? Anyone who has done a 1031 exchange of real property will recognize the 180-day reinvestment window.)
Whence can these capital gains derive? Eligible capital gains typically have come from the sale of real estate; for these purposes, the definition has been expanded to include the sale of stock, mutual funds, collectibles, and businesses in addition to real estate. Note, however, regulations are still being codified and can seem somewhat arbitrary. For instance, for the time being, an operating zone business may not operate “sin” businesses such as massage parlors, gambling facilities or liquor stores, while an opportunity zone fund may directly own and operate a casino.
Critics point to potential concerns about this legislation. For instance, while the vast majority of QOZs include swaths of low-income residents, some include more affluent pockets where investment may not benefit those who need it most. Loopholes are being addressed to maximize the effect for disadvantaged communities.
Who Should Consider Investing?
If you’ve invested in real estate before, or are a long-term investor, these may be a great way to reduce or eliminate outright your capital gains taxes.
- Capital Gains: Clearly, unless you have accumulated capital gains, don’t waste your time. If your gain is sizeable, take a closer look. Note, however, that minimum investment sizes usually vary from as little as $100,000 to more than $1MM;
- 7- to 10-Year Investments: If you are “between investments,” give these a pass. In order to obtain the full 15% step-up in tax basis, you must hold the investment for seven years. If you have other demands for these funds, an investment in a QOZ is not appropriate.
- Reinvestment Requirement: The seven-year time frame ends in December of 2026 when tax payments are due; therefore, investors will need to sell securities in which they have gains in 2019 and reinvest in a QOZ within 180 days to take full advantage.
- Lock-up Periods: While not consistently, some QOFs impose lock-up periods to enable them to identify the property to buy and satisfy the “improvement” requirements. So, it is not uncommon to have lock-up periods of 12 years or more.
- Fees: While a direct investment is unlikely to carry a fee, investors seeking to diversify their portfolios in a Qualified Opportunity Fund are likely to pay management fees that will partially offset their tax benefits.
How Can I Invest in Them?
First of all, you don’t need to live or work in the zone. Second, while typically you are investing in real estate, investments are not limited to it. Investments that qualify can include business partnership interests, capital resources, e.g., factory equipment, as well as real estate — hotels, apartment buildings, parking garages, storage units, etc.
You can invest in two ways:
- Direct ownership in a Qualified Opportunity Zone Property (QOZP) – that is tangible property (buildings, equipment, machinery, etc. that is used in a trade or business and was acquired by the QOF after December 31, 2017.
- Investing in a corporation or partnership (or LLC that is treated for tax purposes as a partnership) that invests in QOZP.
Opportunity Zone investing offers significant tax advantages to the savvy investor. We recommend you consult with your tax advisor before making any investment of this nature. Regulations surrounding QOZs are still evolving, representing a potential risk to the investor.