Opportunity Zone Funds
A tax-advantaged investment vehicle that continues to be a valuable strategy for investors.
A Qualified Opportunity Zone (QOZ) fund is an investment vehicle that allows investors to defer or avoid capital gains taxes on the sale of investment properties located in certain economically distressed areas or communities.
There are more than 8,700 census tracts in U.S. urban, suburban, and rural areas that America’s governors and mayors have designated as QOZs. To qualify, these properties must be in an “opportunity zone” as designated by the state in which it resides and certified by the U.S. Department of the Treasury. The designation was created under the 2017 Tax Cuts and Jobs Act to stimulate growth and improve struggling economic areas of the country.
The National Council of State Housing Agencies has a regularly updated directory of multi-project QOZ funds which, as of January 2024, lists over 240 funds representing nearly $50B in anticipated investment that have a national, regional, or state focus and cover industries varying from commercial real estate to affordable housing and more.
In many cases, opportunity zone properties are new construction. However, there are certain circumstances under which a pre-existing property within the zone can qualify. A fund that purchases a pre-existing property must make “substantial improvements” to the property, defined as equal to the fund’s initial investment into the property over a 30-month period.
Therefore, if a fund were to acquire a property for $5 million, they would have to invest an additional $5 million in improvements over the next two and a half years. Some types of properties, such as golf courses and gambling establishments, are ineligible for opportunity zone investments.
According to the IRS, investment into an QOZ fund can provide investors with significant tax advantages, and even savings, depending on how long the investment is held. Current law allows QOZ investors to defer paying taxes on their investments until 2026. If a QOZ investment is held for 10 years, any appreciation on the investment essentially becomes tax-free.
Certain expired provisions of the law allowed QOZ investors to enjoy a 10% reduction in initially deferred capital gains. For instance, if the investment was held for five years, 10% of the original gains invested became tax-free due to a step-up in tax basis. Any depreciation in the fund also decreases the tax-basis of the original investment. And, if the investment was held for seven years, an additional 5% of the gains became tax-free.
However, the deadlines for investments to achieve both benefits passed on December 31, 2021. Even though the deadlines have passed, QOZ funds still offer clients the opportunity to defer tax on 2021 capital gains for up to five years into the future.
Because of the 2026 deadline for declaring deferred capital gains, investors would have had to make an investment on or before December 31, 2021 in order to claim the 15% and 10% step up in tax basis. While QOZ investors can no longer receive a step-up in basis, the good news is that the majority of the potential tax benefit comes from the ability to exit the investment tax-free if held for 10 years.
The basic rules governing QOZ funds were finalized in late 2019, with very little additional guidance released since, save for a few updates related to the COVID-19 pandemic.
Eligible Capital Gains
When investing in opportunity zones, investors rollover capital gains from one investment to another. But there are some restrictions on where those gains can come from. Only capital gains that are taxable in the United States may be invested. Non-residents and foreign corporations may still make investments if their capital gains are connected to a U.S. trade or business.
As with 1031 Exchanges, QOZ Funds allow for up to 180 days between the sale of an investment and the reinvestment into the new fund. For certain types of investors, there are rules governing when that delay period starts. Investors that have a stake in a partnership, S corporation, are beneficiaries of an estate, or non-grantor trusts may start their investment window from the date on which that entity must hand in their tax return (excluding extensions).
If investing gains from a Real Estate Investment Trust or a Regulated Investment Company, investors may start their investment window from the end of the tax year, or the investor may elect to start their window at the date when they receive their capital gains dividends. Proceeds from installment payments may be invested even if the initial payment was before 2018.
QOZ funds remain a beneficial tax-advantaged option for long-term investing in private capital, while creating jobs and improving economic outcomes for people living in economically distressed communities.
Inheritance of Investments
QOZ fund investments can be passed on to heirs. This is significant, as the majority of tax benefits come after the investments have been held for 10 years, which leaves a lot of room for uncertainty for older investors.
Tax Exclusion of Other Gains
In addition to appreciation on the original investment, other types of gains related to the opportunity zone may be excluded from taxation only after the investment is held for 10 years. If a property within a QOZ fund is sold, investors may choose to exclude profit from the sale. Any profit from such a sale would reduce the amount of the investors’ interest in the fund, as the asset value of the fund would be reduced. Other gains, such as distributions by a corporation or partnership may qualify for exclusion if, for tax purposes, they are treated as gains from the sale of property.
Post Guidance Traction
With the rules establishing a year-end deadline to take advantage of the tax benefits offered by QOZ funds each year, traction for this investment type continues to grow. QOZ funds in 2022 raised close to $10 billion in equity investment, bringing the cumulative total of QOZ fund equity raised to $34.09 billion since 2017.*
QOZ funds remain a beneficial tax-advantaged option for long-term investing in private capital, while creating jobs and improving economic outcomes for people living in economically distressed communities. Like any investment, QOZ funds come with risks, including illiquidity, loss of principal, and more.
The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security.
*Source: QOFs Tracked by Novogradac Reach $34.09 Billion in Equity Raised, Nearly $10 Billion in 2022, Michael Novogradac, January 31, 2023