Commercial real estate investors are always happy to make a profit on a deal. But that profit can also come with a big tax bill. Traditionally, savvy real estate investors have used tax deferral strategies like the 1031 Exchange to shield profits and allow their portfolios to grow tax-deferred. While this is a very effective strategy and has proven to be successful over time, there is another tax-deferral strategy that has grown in popularity in recent years. It involves an investment in a Qualified Opportunity Zone.
What is an Opportunity Zone?
Opportunity Zones were created by the federal government with the passage of the 2017 JOBS Act. They are defined by the IRS as “an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.”
The idea behind identifying Opportunity Zones and giving them preferential tax treatment is simple—to define the areas of greatest need, and create an incentive for private investment to flow into them. In doing so, the resulting economic development creates jobs and income that can be further reinvested in a harmonious cycle meant to lift low-income communities out of distress. As soon as state and local leaders learned of the program, they rushed to identify Opportunity Zones in their own cities.
Opportunity Zone Requirements
Under program rules, a community qualifies as an opportunity zone if it meets certain income and location criteria, and if it is nominated for such designation by the state. Once presented, the nomination must be certified by the Secretary of the U.S. Treasury via delegation of authority to the Internal Revenue Service.
Although the legislation is fairly recent, it has proven to be very popular. In the wake of its passage, thousands of areas have been qualified as Opportunity Zones, and it has the potential to become one of the largest community revitalization programs in United States history. A complete list of approved Opportunity Zones can be found in Revenue Bulletin 2018-48, where they are organized by State, County, and Census Tract.
What is the Tax Incentive to Invest In an Opportunity Zone?
The primary incentive created by the Opportunity Zone program is preferential tax treatment., which can be realized in a two-step process.
First, the incentive creates a mechanism that allows investors to liquidate an existing investment and defer capital gains taxes on it by re-deploying the proceeds into something called a “Qualified Opportunity Fund.”
Once invested, capital gains taxes on the Opportunity Fund Investment can be deferred or eliminated, depending on the holding period. If held for more than five years, there is a 10% tax reduction. If held for more than seven years, there is a 15% reduction. And, if held for more than 10 years, capital gains taxes are eliminated completely through a step-up in cost basis equal to 100% of the real estate investment’s market value at the time it is sold or exchanged. This is a powerful incentive that has led many to inquire about Qualified Opportunity Funds.
What is a Qualified Opportunity Fund?
A Qualified Opportunity Fund (QOF) is “an investment vehicle that files a federal tax return as a partnership or corporation and is organized for the purpose of investing in Qualified Opportunity Zone property.” To receive an Opportunity Fund designation, a private partnership or Corporation must self-certify by filing a form with its federal income tax return. In addition, the fund must meet the following requirements:
- Properties must be purchased after 12/31/2017
- Must hold at least 90% of its assets in a Qualified Opportunity Zone (QOZ). Holdings are calculated as the average percentage of Qualified Opportunity Zone property held on the last day of June and on the last day of December. If the percentage falls below 90%, the fund may be subject to penalties.
- If a property ceases to be in an Opportunity Zone, it will continue to be treated as such for the lesser of five years or the date of sale.
Once established, the partnership, corporation and fund manager must commit to maintaining compliance with rules related to how they deploy their capital. Specifically, Opportunity Funds must deploy investor capital in:
- Real estate or other hard assets within the boundaries of a qualified Opportunity Zone
- A business where most (or all) of the operations are run in a qualified Opportunity Zone
- A partnership with a business currently operating in a qualified Opportunity Zone
Like any investment, there are benefits and risks to Opportunity Fund investment.
Benefits of Opportunity Fund Investing
Aside from the significant tax advantages, there are other benefits that make an Opportunity Fund investment worthy of consideration:
- Increased Portfolio Diversification: Because real estate price movements tend to have a low level of correlation with publicly traded stocks and bonds, adding exposure to real estate can provide a degree of diversification to an investor’s portfolio.
- Social Benefits: Because Opportunity Funds are specifically required to deploy their capital into areas that need it most, there are social benefits from the investment. If deployed correctly, some of the country’s most economically vulnerable residents will benefit with new jobs and income to support their families and communities.
- Retirement Planning: When managed correctly, Opportunity Fund investments can help individual investors plan for retirement by accelerating the tax-free growth of their portfolio.
Despite the significant benefits, a Opportunity Fund investment may not be suitable for everyone. Potential investors should consider the following risks:
- Loss of Principal: By necessity, Opportunity Fund investment capital is deployed into economically distressed areas that may not have the infrastructure to support it. As such, it is not guaranteed that all projects will be successful, making the loss of principal possible.
- Lack of Liquidity: In order to receive the tax benefits, an Opportunity Fund investment must be held for between 5 and 10 years. As such, it is important to consider upcoming cash requirements to determine if it is feasible to tie up capital for that amount of time.
- Market Conditions: All real estate investments are subject to market risk, but it may be particularly acute in Opportunity Zones. There is a risk that the project may not be a good fit for the community, that the tenants aren’t able to pay their rent, or that significant changes in interest rates impact the project’s economic viability.
For those that are comfortable with the risk, an opportunity zone investment can be an effective tax-deferral alternative to the traditional 1031 Exchange.
Interested in Learning More?
Given that Opportunity Zones and Opportunity Zone Funds are still relatively new, the IRS has published an F.A.Q. document that provides additional information about Opportunity Zone Investing and how it can be used as an effective tool to defer taxes and increase net worth.
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our real estate investing opportunities, including qualifying opportunity zone investments, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.