One of the biggest challenges investors prioritizing assets such as stocks, businesses, and real estate face is selling and reinvesting without triggering a significant capital gains tax liability.
While traditional 1031 tax-deferred exchanges are a popular strategy for commercial real estate, it can often take time to find a suitable replacement property, especially within an exchange’s limited time frame.
Investors in the stock market face even more of a challenge. Since April 2009, the S&P 500 Index has increased by over 386% (as of July 18, 2021). Today, investors who want to sell fast face an oversized tax bill because they can only use 1031s with real property.
That’s likely one reason why so much capital from asset sales has been flowing into Opportunity Zones (OZ) investments in the last several years. About $34.7 billion in equity has been raised for Qualified Opportunity Funds (QOFs) as of 2023, from over 700 QOFs.
This article will discuss everything you need to know about Opportunity Zones, Opportunity Zone Funds, and the investment incentives and tax benefits they can provide.
What are Opportunity Zones?
The Tax Cuts and Jobs Act (TCJA) passed by Congress in December 2017 created numerous incentives for businesses and investors, including the Qualified Opportunity Zone (QOZ) program.
The program aims to motivate economic growth and investment in low income communities in the United States and US territories with tax incentives from opportunity zones. The US Department of Housing (HUD) maintains a map of opportunity zones for all 50 states and territories.
- Opportunity zones generate economic growth with long-term investments in distressed areas, including low-income urban areas, rural communities, and attractive neighborhoods adjacent to distressed areas.
- Over 15% of the US population lives in a distressed area, allowing QOZ investors to help with job creation and small, community-based businesses.
- Investments in opportunity zones and QOFs include assets such as infrastructure, industrial projects, workforce, and multifamily housing.
- Profits from the sale of an asset invested in a Qualified Opportunity Fund (QOF) within 180 days from the transaction date have capital gains taxes fully deferred through December 31, 2026.
- Capital gains taxes owed are reduced by 10% if the QOF investment is held for at least five years up to and including year-end 2026.
- Gains from investments held in a QOF for at least ten years are excluded from the capital gains tax.
What is a Qualified Opportunity Fund (QOF)?
For most investors, investing in a Qualified Opportunity Fund is the easiest way to participate in a Qualified Opportunity Zone property. The IRS defines a QOF as an investment vehicle filing a partnership or corporate federal income tax return organized to invest in a QOZ property:
- QOF must be certified by the US Treasury or self-certified according to IRS guidelines.
- 90% of the assets of a QOF must belong within a specified QOZ.
- Three main types of QOF assets are business property such as real estate, stock of companies in a QOZ, and a partnership interest in a business located in a QOZ.
How were Opportunity Zones Selected?
The IRS lists over 8,760 Qualified Opportunity Zones in all 50 states, the District of Columbia, and United States Territories. Along with the mayor of Washington, DC, governors of each state and territory nominated census tracts, which were then officially designated as opportunity zones by the US Department of Treasury.
Regulations require census tracts to meet the following criteria to qualify as Opportunity Zones:
- A poverty rate of 20% or more
- Median family income of no more than 80% of the statewide median family income for rural areas
- Median family income of no more than 80% of the statewide or metropolitan median family income for urban areas
Adjacent census tracts also qualify
Not all Opportunity Zones are located in low-income areas. The IRS also allows census tracts to be eligible as opportunity zones if contiguous to (touching) another lot with a median family income of no more than 125% of the standard median family income in any neighboring qualified opportunity zones.
Who is Investing in Opportunity Zones?
Although deferring capital gains tax isn’t a requirement for investing in Opportunity Zones, it’s one of the top advantages of opportunity zone investments.
Investors with a long-term investment horizon who receive gains from any asset – including stocks and bonds, precious metals, cryptocurrencies, artwork, and real estate – receive benefits right away and over the next several years from opportunity zones:
- Deferred capital gains taxes due are reduced by 10% and are not payable until the 2027 tax year.
- Additional capital gains from opportunity zones’ investments are tax-free, provided they remain held for at least ten years.
- Qualified Opportunity Funds may offer risk-adjusted returns due to preferential tax treatment and incentives and the potential for asset growth over the holding period.
- They’re an attractive alternative for 1031 exchange real estate investors because they provide a full 180 days to identify and invest in income properties for sale, compared to the 45-day identification period rule of a traditional tax-deferred exchange.
- Only the capital gains portion from a sale must be invested in Opportunity Zones versus all of the net proceeds, as when conducting a 1031 exchange.
How to Invest in Opportunity Zones
In 2020, the White House Opportunity and Revitalization Council presented the Opportunity Zones Best Practices Report. Some of the insights for investing in Opportunity Zones highlighted in the report include:
- Local governments are best positioned to understand their communities’ unique strengths and needs. For example, Charleston, South Carolina, has created local rules to allow unlimited density and lower parking requirements for affordable housing in Opportunity Zones.
- States, such as Louisiana, have adopted legislation providing an up to 10-year reduction of property taxes on renovations and improvements of existing commercial and owner-occupied structures in Opportunity Zones.
- Qualified Opportunity Funds have begun focusing on affordable housing, such as a multifamily mixed-use project in Seattle ensuring 20% of the nearly 300 apartments are reserved for workforce housing.
Positive Impact of Opportunity Zone Investments
Opportunity Zones have received some criticism as another way to make the wealthy wealthier. However, as Connect CRE reports, Opportunity Zones are continuing to flourish in secondary markets as nonprofits, economic development organizations, and local and state governments look for ways to make their neighborhoods better places for residents, businesses, and investors:
- Affordable housing becomes more feasible due to a lower cost of capital through tax-advantaged QOZ dollars.
- Investing in existing businesses helps expand to underserved parts of the local community.
- QOFs can be designed to form new companies and scale up existing ones that agree to local their headquarters in opportunity zones, helping create new jobs and higher economic growth.
The Bottom Line
Investing in Opportunity Zones offers a wide range of tax incentives and financial benefits while significantly impacting the economic growth of underserved communities.
Ready to find your next QOZ investment? Use the filters on Crexi to quickly find opportunity zone properties for sale.