Managing Partner of Perch Wealth, focused on providing customized real estate and other alternative investment solutions for investors
To stimulate economic growth and development in lower-income areas, the federal government launched the “Opportunity Zone” program in 2017 as part of the Tax Cuts and Jobs Act.
While the program has proven to be an excellent alternative for deferring, reducing or even excluding capital gains tax altogether, investors still have questions. In this article, I clarify why and how investors might participate in opportunity zones.
What is a qualified opportunity zone?
A qualified opportunity zone (QOZ) is an economically distressed community where new investments may be eligible for preferred tax treatment under certain conditions. In total, there are more than 8,700 census tracts designated as QOZs. These communities all had a poverty rate of at least 20% as of the 2010 census (the most current data at the time of establishing the zones).
Qualified Opportunity Funds
To invest in a QOZ, an investor must use a qualified opportunity fund (QOF). A QOF is an investment vehicle organized as either a partnership or corporation that holds at least 90% of its assets in QOZ property. A limited liability company (LLC) may be a QOF if it chooses to be treated as a partnership or corporation for federal income tax purposes and is organized specifically to invest in a QOZ property.
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Per IRS guidelines, a QOF must double its basis within 30 months to qualify for the tax benefits and provide a “substantial improvement” to its assets.
QOF Tax Benefits
QOFs offer a unique opportunity for investors selling a range of investments, including, but not limited to, stocks, bonds, real estate, closely held business assets, cryptocurrency, jewelry and art. When the gains realized from the sale of these assets are reinvested into QOFs, an investor can potentially benefit from the following “triple-layer” tax incentives:
Deferral: Those who roll over their capital gains into a QOF can defer capital gain recognition from the original investment until December 31, 2026.
Reduction: The amount of capital gain recognized from the original investment is reduced by 10% after achieving a five-year holding period if that five-year holding period is achieved by December 31, 2026.
Exclusion: Long-term investors are eligible to pay no tax on the appreciation of their QOF investment upon disposition of that investment, regardless of the size of that profit, if the assets held in that QOF are held for at least 10 years. However, the tax benefits are not guaranteed. It is possible, due to tax, regulatory or investment decisions, that a fund, or its investors, are unable to realize any tax benefits. It is crucial that investors evaluate the merits of the underlying investment and do not solely invest in an OZ fund for any potential tax advantage.
Furthermore, OZ investments qualify during a 1031 exchange, meaning investors trading from one asset can trade into an asset located in a QOZ to defer paying capital gains.
However, it’s important to note that these tax benefits are not guaranteed and costs from the transaction may impact returns and potentially outweigh the tax benefits. Furthermore, income from the property and the assets depreciation schedule may affect an investor’s tax bracket or tax status, possibly resulting in an unfavorable tax ruling.
Risks Associated With Opportunity Zones
Since opportunity zones were developed to promote investments in underperforming markets, and since their inception is relativity newer, there are risks that investors should be aware of.
OZ funds are at higher risk compared to alternative investment options.
Since QOZs are newly formed entities with no operating history, there’s no assurance of investment return, property appreciation, profits or resale opportunity. Investors must accept the reality that the investment may lose value over time.
OZ investments are generally located in secondary markets, limiting liquidity options.
Underwriting the portfolio holdings in OZ funds can be difficult. As such, market prices for most of a fund’s holdings will not be readily available.
OZ funds are leveraged, which increases the investment’s exposure to factors such as rising interest rates, downturns in the economy and deterioration in the condition of the assets underlying the investments. Assets are also at risk of foreclosure.
If an investor invests in a QOZ via a 1031 exchange, they need to keep in mind that these exchanges are available from private placement offerings and are considered illiquid securities. There is no secondary market for these investments.
The regulatory protections of the Investment Company Act of 1940 are not available with unregistered securities.
These factors can result in more risk for an investor compared to other real estate offerings.
Investing in an OZ is a long-term investment.
Investors pursuing OZ investments should consider that investing in an opportunity zone is a long-term strategy. In most cases, return of capital and realization of gains, if any, do not generally occur until selling or refinancing the asset. Furthermore, if a property loses a tenant or sustains damage, there is a potential for disruption in cash flow distributions.
Regardless, investors must be able to meet their contractual obligation and provide pledged capital. Failure to do so could have adverse consequences, including forfeiture of their interest in the fund.
There’s no guarantee that any strategy will be successful, so prospective investors should stay informed about their investment options. Speaking with a qualified professional can help investors determine whether investing in an opportunity zone is optimal.
Not an offer to buy, nor a solicitation to sell securities. All investing involves the risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.