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What you need to know as an investor

  • Opportunity zones are economically distressed communities designated by the IRS.
  • Accredited investors can buy funds that invest in these areas and benefit from tax advantages.
  • The program aims to stimulate economic development, but it may take time to see an impact.

In an ideal world, investors could find great deals, save money on taxes, and help the communities in which they invest. But is it really possible to achieve all of this at once? That’s what the US government is trying to do with opportunity zones.

However, it can be difficult to meet Opportunity Zone requirements in order to obtain tax benefits, and these offers are not suitable for everyone. But for some, especially real estate investors, the Opportunity Zones look good.

What is an Opportunity Zone?

An opportunity zone is a geographical area “in economic difficulty”, according to the tax authorities. Investors can allocate money to Qualified Opportunity Zones (QOZs) and receive tax benefits, while the community gets a boost to its economy and labor market.

The tax benefit is particularly attractive for real estate investors with unrealized capital gains. Normally, when gains are realized (i.e. you sell an investment for a higher price than you bought it), you will be subject to capital gains tax. But Opportunity Zones allow investors to turn those gains into new investments, potentially deferring and reducing capital gains taxes.

Opportunity Zone History

The QOZ program was created as part of the Tax Cuts and Jobs Act in late 2017. At the time, American households and businesses had about $6 trillion in unrealized gains, according to the economic innovation group.

“I think the government thought that would incentivize people to take those gains and redeploy them to troubled areas and make improvements to those areas,” says Jeffrey Bowden, co-director of the tax department at anchin, an accounting firm. He is also a member of Anchin’s Real Estate Industry Group and Financial Services Practice.

In many cases, investments in Opportunity Zones involve commercial and residential real estate, but they can also include other projects, such as infrastructure or small businesses. States, territories and Washington DC may designate Opportunity Zones to be approved by the IRS.

On April 9, 2018, the IRS designated the first set of QOZs in 18 states. Today, there are approximately 8,700 communities designated as QOZs in all 50 states, Washington, DC, and five U.S. territories (American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and U.S. Virgin Islands).

In April 2022, bipartisan legislation was introduced to extend the deadline for investment in Opportunity Zones from the end of 2026 to the end of 2028. But this bill has yet to pass.

Map of Opportunity Zones

You can find QOZs in your area or search across the United States, including its territories, via a map from the Ministry of Housing and Urban Planning.

As the map shows, Opportunity Zones are widely distributed and predominate in suburban and rural areas. For example, most of Alaska’s North Slope Borough, one of the most remote regions in the country, is located in an Opportunity Zone.

Here is an additional map showing the number of Opportunity Zones by state in the United States.

Qualified Opportunity Funds

To invest in an Opportunity Zone, money must be allocated through a Qualified Opportunity Fund (QOF). These investment vehicles must be incorporated into companies and partnerships under the IRS Filing Requirements to benefit from tax advantages.

In theory, anyone can set up a QOF, but opportunity zone rules can be complex, so these funds tend to be managed by professionals.

“There are a lot of nuances to follow,” Bowden says of creating a QOF. “You can easily trip yourself.”

One of the requirements is that at least 90% of a QOF’s assets must be held in an opportunity zone. QOFs may hold shares, interests or property in a company located in a QOZ. Direct investments in certain types of businesses are excluded, such as golf courses, liquor stores and gambling establishments. However, a QOF could own assets that are then used by these types of businesses, provided it passes a few tests, including that it leases less than 5% of its assets to these businesses.

QOF investments must also meet the requirement to substantially improve the existing property. Rather than simply investing in an existing building and hoping to generate returns from a rising real estate market, you need to invest more in improving the property than the initial investment was worth.

“You have to increase the tax base of a property, excluding property value, by [over] 100%,” says Bowden. “A simple example: If I bought a building for $100 and 20% was allocated to land, that means the base of the building is $80. This means you must invest $80.01 in substantial improvements to qualify.”

How to Invest in QOFs

While some funds have relatively low investment minimums (eg, $500), they are generally geared towards accredited investors. In other words, QOFs are reserved for large investments by wealthy and institutional investors. The National Council of State Housing Agencies (NCSHA) post a list publicly announced QOFs. Investors interested in QOFs can speak with their financial advisor or contact the fund directly.

QOF tax benefits

Investing in an Opportunity Zone allows the deferral of federal capital gains tax. Rather than paying taxes arising from the sale of real estate or other investments in a QOZ, an investor could transfer that money into a QOF.

If all conditions are met, an investor may receive benefits such as a 10% increase in cost base if the investment is held for at least five years, plus an additional 5% if held for at least five years. less than seven years. The higher the cost base of investing in the Opportunity Zone, the less the gain will be realized, which means the investor will owe less capital gains tax.

For example, if your cost base was $1 million and you sold a $2 million investment, you would have a gain of $1 million. But if your cost base was $1.1 million, you would instead be taxed on a gain of $900,000.

But keep in mind that capital gains taxes can only be deferred until the end of 2026, unless the government adds an extension. To meet the five-year holding rule, you should have invested before 2022.

Yet investors can benefit from current investments in opportunity areas. Another tax benefit is that if you hold the investment in an Opportunity Zone for at least 10 years (and sell before 2047), one of those gains could be eliminated. For example, if you invest in a building that has doubled in value from $1 million to $2 million, you could potentially avoid taxes on that $1 million gain.

“If you were looking to get the deal done anyway and you can take advantage of the opportunity zone, I think the benefits the government has provided are quite substantial,” Bowden said.

QOF Disadvantages

While the tax benefits of Opportunity Zones can be attractive, that doesn’t make every investment in an Opportunity Zone a home run.

Whether you’re dealing with a QOF with high fees or the investment just isn’t as financially sound as other places you might allocate your money to, there are plenty of reasons why an investment in an area of opportunity might not be suitable.

“An opportunity zone isn’t going to make a bad deal a good deal, it’s going to make a good deal a better deal or potentially a lot,” Bowden said.

Due to the long period of time you must hold investments to take advantage of tax benefits, your investment is relatively illiquid. Additionally, since QOFs are intended for accredited investors (usually those with a net worth of over $1 million), the barrier to entry is high.

The bottom line

Opportunity Zones are something of an experiment. The initial program was designed to last until 2026 and provide tax benefits to investors investing in the redevelopment of low-income areas. This may be great for some investors who want to reduce their capital gains liabilities, but it’s less clear – at least until now – what the lasting impact on communities is.

Going forward, legislators may renew or redefine Opportunity Zones to increase their impact.