Qualified Opportunity Zones: A Significant Tax Benefit For Investors
The Tax Cuts and Jobs Act, passed in December 2017, contained new Internal Revenue Code Sections 1400Z-1 and 2 aimed at developing economic growth and business in certain designated, distressed, low-income communities around the country known as Qualified Opportunity Zones. The provision provides federal tax benefits to those investors who invest in funds and businesses that target the designated Qualified Opportunity Zone boundaries.
What Is Opportunity Zone
Opportunity zones are a tax benefit created by the Tax Cuts and Jobs Act of 2017 to spur investment in economically distressed communities. In exchange for qualified investments in specific places, a taxpayer may defer and reduce taxes owed on capital gains and earn tax-free capital gains for opportunity zone investments held at least 10 years.
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What Is The Qoz Incentive Program
The QOZ incentive program encourages taxpayers to make long-term investments into qualified opportunity zones.
What are QOZs?
QOZs are regions across the country that are economically distressed. In 2018, each state nominated census tracts from their jurisdiction to be classified as QOZs, and the final QOZ designations were published by the Department of the Treasury later that year.
Taxpayers who realize capital gains from selling another investment can defer their taxable gain if they direct those gains into a QOZ by way of an investment fund known as a Qualified Opportunity Fund . QOFs exist solely to hold assets in QOZs.
Taxpayers can receive one or more of the following possible benefits for their participation in this program:
The 15% step-up incentive has already expired, and the 10% step-up incentive is about to expire, but QOZ investment can still play a role in your clients tax plans. Here are a few paths forward:
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The New Research Fills An Important Data Gap In Understanding Opportunity Zones Impacts
Despite their cost and scope, opportunity zones lack even the most minimal reporting requirements. To shed light on their impact, the new research from Kennedy and Wheeler, based on preliminary tax return data for 2019 and 2020, uses multiple data sources to provide important insights into programs initial impact. The reports four key findings show that:
How Long Should You Hold Your Investment In A Qualified Opportunity Zone
Investors who want to defer taxes on capital gains can receive tax benefits from opportunity zones if they meet specific time requirements for investing the realized gain in a qualified opportunity fund . As a result, investors can postpone paying taxes on realized capital gains until December 31, 2026 .
For the gains to be 100% tax-free, the investment in a QOF needs to be held for 10 years. The combination of tax deferral and tax-free investing can provide a significant advantage to QOF investments versus other traditional investments that are taxed on investment gains. A good adviser should be able to provide a side-by-side comparison for an investor of paying taxes on capital gains today versus deferring them and investing in a QOF with tax-free growth.
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Opportunity Zone Case Study
Taxpayer A sells publicly traded stock on August 31, 2022. The taxpayer originally purchased the stock for $500,000 and sold it for $1.5 million, generating a $1 million capital gain. Later, on or before February 26, 2023, the taxpayer invests $1 million in a QOF. The taxpayer can defer recognition of the $1 million capital gain on their 2022 federal income tax return.
Provided the taxpayer continues to hold their investment in the QOF through December 31, 2026, they will recognize the deferred capital gain at that time. Further, if the taxpayer continues to hold their investment in the QOF for a cumulative total of 10 years, they will pay no tax on the gain realized from selling their investment after the 10-year holding period.
The Opportunity Zone Program In New York State
New York State is participating in the new Opportunity Zone community development program, offered through the Tax Cuts and Job Acts of 2017. The federal program encourages private investment in low-income urban and rural communities. Based on analyses by Empire State Development , New York State Homes and Community Renewal , New York State Department of State and the states Regional Economic Development Councils , New York State has recommended 514 census tracts to the U.S. Department of the Treasury for designation as Opportunity Zones.
to view the list of the 514 approved and designated tracts.
Use the map below to view approved and designated tracts:
Q: What is an Opportunity Zone?A: An Opportunity Zone is a low-income census tract with an individual poverty rate of at least 20 percent and median family income no greater than 80 percent of the area median.
Q: What is the benefit of an Opportunity Zone?A: An Opportunity Zone can receive funds from Opportunity Funds. Opportunity Funds provide investors the chance to put that money to work rebuilding the low to moderate income communities. The fund model will enable a broad array of investors to pool their resources in Opportunity Zones, increasing the scale of investments going to underserved areas.
Q: How many Opportunity Zones may a state nominate?A: Each state may nominate a minimum of 25 total eligible census tracts but no more than 25 percent of the total number of eligible census tracts within the state.
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What Are Opportunity Zones
The areas eligible for submission as Opportunity Zones are low income census tracts with a poverty rate of at least 20 percent and a median family income of less than 80 percent of the statewide or area median income. Census tracts are statistical subdivisions of a county established by the U.S. Census Bureau. Each tract averages between 1,200 and 8,000 in population and the nominated tracts vary in size from 199 acres to 235,352 acres.
Who Can Invest In Opportunity Zones
The opportunity zone provision offers tax benefits to investors with unrealized capital gains gains in the value of investments, like stock, that the government hasnt yet taxed because investors havent yet sold them. Under the provision, investors who sell such investments can defer the capital gains taxes that are otherwise due by rolling the amount of the gains into funds that would invest in opportunity zones.
Investors can take advantage of the new tax break for opportunity zones in up to three ways. First, investors can defer taxes on their capital gains until 2027 if they invest their gains in opportunity zone funds. Second, those who hold their opportunity zone investments for at least seven years also will get a 15 percent cut in the capital gains taxes that they would otherwise pay . Third, and perhaps most significant, those who hold opportunity zone investments for at least ten years will get a permanent capital gains tax exemption for all of the gains they realize on their opportunity zone investments through 2047.
Due, in part, to the complexity of the opportunity zone rules, large investment funds that raise capital from individual investors will create and manage most opportunity zone funds. These investment funds will select the investments, and investment structures, that offer the best prospects for financial returns while satisfying the opportunity zone criteria.
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Potential Risks Of Qofs
There is no guarantee that an investment in a QOF will yield a profit, and it may lose money. If a QOF declines in value, a taxpayer runs the risk that the overall loss in a QOF may be greater than the discount on the initially invested capital gain. Since QOFs are long-term strategies, QOF investors may not have the option to sell to mitigate potential losses. For example, there may be no market to sell the QOF, or a sale would be considered an “inclusion event,” which would cause a QOF investor to recognize some or all of its deferred capital gains5.
Example 4The QOF declines in value during Tiffanys 5 year holding period by 25%, which causes a drop in value of Tiffanys interest from $5 million to $3.75 million. Tiffany’s capital gains tax liability at the end of the holding period should still be calculated on her original $5 million investment and not the current value of the fund. This will be calculated using the 10% cost basis step-up, which reduces the capital gain from $5 million to $4.5 million, but that gain still exceeds the $3.75 million current value of her QOF investment. Had Tiffany recognized her $5 million capital gain initially, rather than invest it in the QOF, she might have considered more conservative investment options that may have allowed her to mitigate potential losses in value
The Potential Tax Benefits Of Qofs
There are three possible income tax incentives for taxpayers interested in investing in a QOF: deferral, discount, and exemption. First, a taxpayer may defer recognizing capital gains from a sale of a capital asset if the capital gains are invested in a QOF within 180 days of the disposition of the property. By investing in a QOF, a taxpayer is able to defer recognition of their capital gains until either the QOF is sold, or December 31, 2026, whichever occurs first. A taxpayer may invest an amount greater than the eligible gain, but only the capital gain portion will be eligible for the tax benefits under the program.
Example 1Tiffany liquidates her portfolio in April 2020 and generates a $5 million long-term capital gain. She invests only the $5 million capital gain into a QOF in December 2020 . By investing in a QOF within 180 days, Tiffany may defer $1.19 million of capital gains tax that would have been payable on her 2020 income tax return.5,6
Next, a taxpayer may receive a potential discount upon recognition of the capital gains that were initially invested in the program. In general, depending on the timing of a taxpayer’s investment and the period the investment is held, up to 10% of the taxpayer’s rolled gain may be permanently exempt from taxation. Specifically, the cost basis of a QOF should increase by 10% after 5 years.
In 2025, Tiffany’s cost basis in the QOF should increase from zero to $500,000 because she would have held the QOF for 5 years.
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Estate Planning With Qofs
If a QOF is gifted to a charity or an individual other than the taxpayer’s spouse, this gift would be considered an inclusion event and may trigger the inclusion of the deferred capital gains in the taxpayer’s taxable income in the year the gift is made. If a QOF is gifted to a grantor trust or distributed to a taxpayers beneficiaries upon death, it should not be considered an inclusion event. (For more information on grantor trusts, please see Trusts and Taxes: Exploring the Federal Income Tax Implications of Trust Strategies.
Further, if a QOF is gifted to a grantor trust or distributed upon death prior to December 31, 2026, there will be no step-up in cost basis in the QOF. Although there is no step-up in cost basis, the taxpayer’s holding period in the QOF will tack on or carry over to the beneficiary of the QOF. However, this may present an income tax issue for the beneficiary if the beneficiary does not hold sufficient liquid assets to cover the impending deferred capital gains tax liability associated with the QOF.
Example 5In April 2020, Tiffany’s cost basis in the QOF is considered to be zero even though she contributed $5 million. In 2021, Tiffany dies and leaves her interest in the QOF to Diana, her 25-year-old daughter.
If a QOF owner intends to distribute a QOF upon death, the owner may want to consider providing additional funds to the recipient to cover the potential income tax liability.
Qualified Opportunity Zone Business
Each taxable year, a QOZ business must earn at least 50% of its gross income from business activities within a QOZ. The regulations provide three safe harbors that a business may use to meet this test. These safe harbors take into account any of the following:
- Whether at least half of the aggregate hours of services received by the business were performed in a QOZ
- Whether at least half of the aggregate amounts that the business paid for services were for services performed in a QOZ or
- Whether necessary tangible property and necessary business functions to earn the income were located in a QOZ.
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Program Mechanics Dont Guarantee Local Residents Will Benefit
Because taxpayers must have unrealized capital gains to invest in an opportunity zone, and capital gains are heavily concentrated among the wealthy, the tax break will directly benefit wealthy private investors. Local residents of opportunity zones will benefit only to the extent that the tax break encourages new investments creates jobs for residents spurs the development of new, affordable housing or creates broader economic improvements that reach local residents.
Unlike some other economic development incentives, however, this tax break does not include rules or tests requiring its direct beneficiaries to make specific investments that actually produce public benefits or requiring that opportunity zone businesses hire workers from, or provide services to, the local community. If anything, its incentives push in the opposite direction: the tax break is worth the most with respect to investments whose value rises the fastest. As a result, investors will likely select investments such as luxury hotels rather than affordable housing based mainly on their expected financial return, not their social impact.
Opportunity Zones: An Overview Of The Benefits And Requirements
Opportunity zones have received a flurry of interest from every corner of the real estate industry, and many are diving in before the IRS has answered key questions about how to structure the investment. The effect of opportunity zone deferral and basis adjustment tax benefits is to enhance the rate of return on a project, thereby making otherwise unfeasible or unfinanceable projects work. While those with substantial capital gain stand to benefit the most, anyone with a long-term investment horizon may stand to benefit from the opportunity. This guide is a resource for those in the real estate industry and should not be construed as tax or legal advice without further consultation with Larsson & Scheuritzel P.C.
The opportunity zone statute that was enacted as part of the Tax Cuts and Jobs Act allows all taxpayers to avail themselves of tax benefits that include temporary tax deferral and the possibility of complete and permanent exclusion of some taxable income. The statute required guidance from the IRS to make the statute usable, and the IRS issued its first set of guidance in late 2018. Below is a very brief summary of benefits of the program and what someone wanting to benefit from the program would need to know. You can access a PDF version of this guide here.
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What Are The Tax Benefits Of An Opportunity Zone
Through an investment vehicle known as an Opportunity Fund, Opportunity Zones provide for both temporary and permanent tax deferral for eligible investors.
- Investment in an Opportunity Fund provides temporary deferral from other investments without immediately triggering recognition of those gains. The deferred gain must be recognized on the earlier of the date on which the EO investment is sold or Dec. 31, 2026.
- Opportunity Zones provide permanent deferral on capital gains if the opportunity fund is held for at least 10 years. The exclusion only applies to gains accrued AFTER an investor makes his/her investment in an Opportunity Fund.
- A qualified Opportunity Fund is a privately managed investment vehicle created as either a partnership or corporation for the purpose of investing in qualified opportunity zone property.
Where Are Opportunity Zones Located And How Are They Created
Opportunity zones are dispersed throughout the country and represent 11% of all U.S. census tracts. Spread throughout a mix of urban, industrial, suburban and rural areas, opportunities zones are home to over 30 million people. You can view an interactive map of qualifying opportunity zones on the U.S Department of Housing and Urban Development website.
Individual states, in collaboration with local governments, were able to nominate a specific geographic area for the Qualified Opportunity Zone program through March 21, 2018. These areas were required to meet certain low-income requirements, among other criteria. The actual certification as an opportunity zone comes from the IRS.
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How To Invest In Qualified Opportunity Funds
Establishing a QOF is not a simple task. For that reason, most investors choose to take advantage of the Opportunity Zone tax incentives by placing their qualified capital gains into an existing QOF investments run by an institution. Like any professionally managed fund, these QOFs manage the underlying investments with the goal of generating returns for their investors.
The Steps For Investing In An Opportunity Zone
1. Find out where opportunity zones are available.
Currently, there are 8,741 qualified opportunity zones across the U.S., including the District of Columbia, and other U.S. territories. An interactive map is available on the Department of Housing and Urban Developments website that shows all the QOZs.
While qualified opportunity zones exist in all 50 states, New York, Arizona and Texas are among the states with the highest percentage of opportunity zones.Many of the countrys top real estate development firms offer institutional quality real estate investments in ready-made qualified opportunity zone funds , available to accredited investors only. These investments include Class A apartment buildings, industrial warehouses, life science facilities, self-storage, student housing and hotels.
An investor may wish to consider the convenience of investing in a ready-made institutional quality QOF that invests in assets that would be out of reach for most individual investors due to the investments size and scope. Many of these funds are capitalized with $100 million or more. QOFs of this nature are available in fractional denominations from securities registered investment advisers and/or broker-dealers.
2. Create your own opportunity fund, or find one that is accepting investment capital.
3. Invest in qualified opportunity zones and apply investment strategies for leveraging capital gains.
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