What Investors Need to Know about Investing in Opportunity Zones
The commercial real estate market has been in a bull market for several years now, but not all communities have benefitted equally. In order to stimulate economic growth and development in lower-income areas, the federal government launched the “Opportunity Zone” program in 2017, with investments beginning shortly thereafter. It took several months for Opportunity Zone guidance to be issued (and then refined) by the IRS, but today, investors will find that investing the proceeds from the sale of certain assets into a qualified opportunity zone can be an excellent tool for deferring, reducing and even totally excluding capital gains tax.
In this article, we look at why and how investors might invest in opportunity zones and then compare this investment vehicle to 1031 exchanges and DSTs, two other tools that can be potentially leveraged for realizing similar tax benefits.
What is a Qualified Opportunity Zone?
A qualified opportunity zone, or QOZ, is an economically distressed community where new investments, under certain conditions, may be eligible for preferred tax treatment.
The QOZ program was created by the federal government in 2017 as part of the Tax Cuts and Jobs Act. The “Investing in Opportunity Act” legislation is defined in IRS Code Section 1400Z. Under this legislation, the governor of each U.S. state and territory was able to nominate up to 25 percent of their qualifying census tracts as QOZs.
To be eligible for nomination, the census tract must have had a poverty rate of at least 20 percent as of the 2010 census.
In total, there were more than 8,700 census tracts designated throughout the U.S., District of Columbia and U.S. territories.
Qualified Opportunity Zone Funds
In order to invest in a QOZ, an investor must do so through a Qualified Opportunity Zone Fund – or QOF. A QOF is an investment vehicle organized as either a partnership or corporation and must hold at least 90 percent of its assets in QOZ property. An LLC may be a QOF if it chooses to be treated as either a partnership or corporation for federal income tax purposes and if it is organized for the purpose of investing in QOZ property.
Per IRS guidelines, a QOF must double its basis within a 30-month period in order to qualify for the tax benefits and provide a “substantial improvement” to its assets.
QOF Tax Benefits
The primary reason investors are drawn to QOZs is for the potential tax benefits associated with investing in these areas. QOFs offer a unique opportunity for investors planning to sell 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 re-invested into QOFs, an investor can potentially benefit from the following “triple layer” tax incentives:
Deferral: Those who rollover 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 percent after achieving a five-year holding period, as long as 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 ten years.
QOFs vs. 1031 Exchange
At first glance, it seems as though the tax benefits associated with investing in a QOF are similar to those realized when re-investing through a 1031 exchange. There are notable differences, however.
First, only proceeds from the sale of real estate can be rolled into a 1031 exchange. Capital gains from other assets, including stocks, bonds and business equipment, can be re-invested into a QOF.
A second difference is that a QOF investor is NOT required to identify a replacement property within 45 days, nor must they use a qualified intermediator like they do with a 1031 exchange. Instead, investors are given 180 days to re-invest the proceeds from the sale of their prior assets into a QOF.
Yet another difference is that to be eligible for a 1031 exchange, the investor must invest the value of their original investment and the gains realized upon sale into another like-kind asset. When investing in a QOF, the investor simply has to invest the gains—they can pocket their original investment.
One benefit to utilizing a 1031 exchange, however, is that gains can be reinvested in any geography. Investors are not limited to specific census tracts as they are when investing in QOFs.
QOFs vs. DSTs
Another popular way to defer paying capital gains tax on the sale of real estate is by re-investing the proceeds into a Delaware Statutory Trust, or DST. DSTs are eligible for the same tax benefits as 1031 exchanges, which means investors can use DSTs as a vehicle for deferring capital gains tax, sometimes indefinitely.
Investors often utilize DSTs in conjunction with 1031 exchanges, but as an alternative to “whole property” 1031 exchanges.
In short, investors can role the proceeds of the sale of their property – in whole or in part – into a DST. The investor will then hold proportionally fractional ownership in the property (or properties) owned by the DST. One of the primary draws to investing in DSTs is that DSTs are generally already established with a portfolio of properties already identified, which allows investors to move faster than they would be able to if conducting due diligence on whole-property 1031 exchanges.
While both QOFs and DSTs offer significant tax benefits, there are differences between the two investment vehicles to consider.
Investments in QOFs are intended for ground-up and value-add investments. DSTs are better suited for non-speculative, stabilized and cash-flow generating properties. QOF capital gains deferred through 2026 are eligible for a partial-step up; they must be held for at least ten years to be excluded. DST investments are not eligible for exclusion, but may be deferred indefinitely.The asset basis is stepped up to fair market value at the time of the investor’s death.
Only capital gains from real property may be re-invested in a DST whereas the short- and long-term gains on the sale of nearly all assets can be re-invested in a QOF.
QOF investments have strict geographic boundaries compared to DST investments, which can be made anywhere in the U.S. regardless of the census tract or local poverty rate.
DSTs are required to identify a property or portfolio of properties prior to accepting investments. QOFs are not subject to the same regulation. QOFs may have what is known as a “blind pool,” meaning that capital deployment is flexible as long as 90 percent of assets remain in an OOZ.
Which Investment Vehicle is Right for You?
Opportunity Zone Funds, 1031 exchanges and Delaware Statutory Trusts all have their own pros and cons. Each can be an equally effective method for realizing tax benefits. Often, these strategies can be used in conjunction with each other.
When determining which investment vehicle is best for you, consider the following:
How much authority do you want to have over how funds are invested? The usual “blind pool” nature of QOFs means that investors are often unaware of exactly how their capital will be invested. This is different than investing in a 1031 exchange or DST, where the assets have already been identified.
Is a set-up in basis important to your legacy planning? When an investor passes away, any investment they have made in a QOF will not receive a step-up in basis to market value as it would if it had been invested in a DST. Therefore, the heirs will be forced to pay the tax consequence upon selling ownership in the QOF.
Has the asset you are planning to sell already been depreciated? Unlike 1031 exchanges and DSTs, QOFs do not allow you to defer depreciation recapture on the underlying asset upon sale. Under current tax law, 1031 exchanges and DSTs allow you to perpetually defer depreciation recapture.
What is your risk tolerance? The purpose of creating QOZs was to spark economic development in economically distressed areas. This requires speculative development of ground-up (i.e., new construction) or heavy value-add projects. Opportunistic real estate deals such as these can be riskier than investing in a potentially stable, cash-flowing asset when investing through a DST. Those with a higher risk tolerance might be drawn to QOFs whereas those with a lower risk tolerance might opt for investing in a DST instead. If you are considering selling investment property, it is worth understanding the full suite of options available for maximizing the value of your proceeds. Contact us today. Our team would be happy to consult with you about which strategy might be best for your specific investment goals.