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It’s been two years since the Tax Cuts and Jobs Act of 2017 created opportunity zones to incentivize investments in nearly 9,000 distressed communities across the U.S. As senior vice president at Capital Square, a real estate investment sponsor, I connect accredited investors with the potential for tax benefits from qualified opportunity zone investments.
Many investors enter into a qualified opportunity zone fund (QOF) as their vehicle to participate in the opportunity zone program. As of October 2019, the National Council of State Housing Agencies (NCSHA) Opportunity Zone Fund Directory lists 183 opportunity zone funds that expect to raise $44 billion for opportunity zone investment. At our firm, we’ve launched five opportunity zone funds this year.
QOFs have three levels of tax incentives: initial tax deferral, partial elimination and complete elimination of capital gains taxes on a QOF investment’s appreciation if the investment is held for at least 10 years.
What’s Changed In Two Years?
Opportunity zones were created with a strict timeline in place, and effective January 1, 2020, the first 5% reduction in the appreciation capital gains tax will be lost. Investments had to be made into a QOF by December 31, 2019, to receive the full 15% reduction on the original deferred capital gains taxes. But this doesn’t mean a reduction isn’t available, nor that the complete elimination of capital gains taxes on the profits from a QOF investment is no longer possible.
This means that on tax day in April 2027, investors participating in a QOF are required to pay taxes on original deferred capital gains used to enter the fund. If the investment was held for seven years, taxes paid on the original deferred capital gains would have a reduction of 15%. However, beginning January 1, 2020, investors will receive a 10% reduction instead. This has some investors questioning whether opportunity zones will be viable next year.
The short answer: Yes, opportunity zones still have meaningful tax benefits.
December 31 Is A Deadline, Not An Expiration Date
For the next two years, beginning January 1, 2020, investments in a QOF will still qualify for a 10% reduction in capital gains taxes on the appreciation of the investment. If the investment is held 10 or more years, capital gain taxes will be eliminated.
Any Capital Gains Qualify
Investors might be hesitant to offload a current investment due to the potentially sizable taxes on the capital gains from the sale. These investors can roll all capital gains taxes from the sale into a QOF. Unlike other investment vehicles, capital gains from the sale of almost any type of appreciated asset can be reinvested in a QOF. This includes stocks, bonds, real estate, business sales, art, bitcoin and more. Perhaps the most important requirement is that capital gains from a sale must be invested into a QOF within 180 days of gain recognition.
Potential For Risk-Adjusted Returns
QOFs may generate attractive, risk-adjusted returns. Distributions will typically be paid to the investor on a monthly or quarterly basis via a mailed check or direct deposit. There’s also the potential for growth when the investment is taken full cycle.
A Safety Net For 1031 Exchange Investors
Timing is critical for those looking to invest in a 1031 exchange — they must close or identify a replacement property within 45 days to receive its tax advantages. QOFs can provide a backup option to 1031 exchange investors who miss that deadline by providing an additional 135 days to invest. Additionally, they’ll only need to invest the capital gains portion of the original sale rather than exchanging all the net proceeds.
Doing Good By Investing In America
The Tax Cuts and Job Acts of 2017 was designed to stimulate long-term private investments in low-income urban and rural communities. By providing tax benefits, opportunity zone investments are intended to promote economic growth in distressed areas. It’s important to note that many qualifying opportunity zones are in desirable neighborhoods near distressed areas.
Recent data from the Economic Innovation Group shows that one out of every six U.S. citizens lives in an economically distressed ZIP code. Bringing jobs back to these towns and cities means planting the seeds for businesses, construction, manufacturers, healthcare providers and retailers in new locations. In turn, these organizations can spur the growth of small businesses like coffee shops, restaurants, dry cleaners, barbers, hair salons and other retailers. Opportunity zones exclude “sin businesses,” such as private or commercial golf courses, country clubs, massage parlors and others.
Real estate investment firms and developers are raising up to $5 billion for each opportunity zone fund. They’ll invest in every state, plus Puerto Rico and the Virgin Islands, and they intend to create a wide variety of housing options, including affordable housing, traditional multifamily housing, senior housing, student housing and workforce housing. Additionally, they’re expected to develop projects related to energy, infrastructure, farmland, hotels, industrial facilities, parking structures, retail, stadiums and more.
Different Types Of QOFs
It’s important to consider whether a QOF is project-specific or a blind pool. A project-specific fund has already earmarked the capital for a particular building, land or business. A blind pool QOF’s sponsor determines how equity from the fund will be allocated into different opportunity zone projects after proceeds are received from investors. A blind-pool fund investment typically is made based on the confidence in the fund’s management to choose appropriate investments.
Regardless of the structure, all QOFs must invest at least 90% of their assets in qualified opportunity zones.
The Opportunity Is Still In Opportunity Zones
Although 2020 investments in QOFs only receive a 10% instead of a 15% reduction, there’s still substantial incentive to invest. Investors can benefit from a deferral on original capital gains with the potential to receive monthly distributions on the QOF investment. Most importantly, they have the potential of receiving complete elimination of capital gains taxes if they remain in the investment for 10 years, and they’ll still be investing in America.