Are you interested in investing and having your taxes deferred, reduced, and even eliminated from your investment? Do you want to help communities become affordable places to live? Do you want to help families have a roof over their heads? If your answer is yes, then investing in a Qualified Opportunity Fund may be the right option for you.
Under President Trump, the Tax Cuts and Jobs Act paved the way for Qualified Opportunity Funds to exist.
Real estate investors looking to take advantage of the perks of purchasing Qualified Opportunity Zones must first set up a Qualified Opportunity Fund.
Here’s everything you need to know about real estate investments in Qualified Opportunity Zones through Qualified Opportunity Funds.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
What is a Qualified Opportunity Zone?
Qualified Opportunity Zones (QOZ) are designated areas that provide tax advantages for real estate investors. These large-scale projects are often out of reach for the average investor. But, by pooling financial and intellectual resources in a real estate syndication fund, investors can tackle properties and projects larger than an individual could manage on their own.
More specifically, the IRS defines an Opportunity Zone as “…an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.”
You may be wondering where to find these Qualified Opportunity Zones. While the IRS currently does not have a visual map of the census tracts available on their website, here are two places you can look for listings of available QOZs:
Additionally, approved QOZ properties include qualified opportunity zone stock, a qualified opportunity zone partnership interest, and qualified opportunity zone business property.
To take advantage of the associated tax benefits, the IRS requires that QOZ properties be purchased with a Qualified Opportunity Fund (QOF).
What is a Qualified Opportunity Fund?
According to the IRS, a Qualified Opportunity Fund is “An investment vehicle organized as a corporation or a partnership to invest in Qualified Opportunity Zone property (other than another QOF) that holds at least 90% of its assets in qualified opportunity zone property.”
Basically, a Qualified Opportunity Zone Fund allows you to invest in equipment, tangible property, or businesses in which 50% or more of gross income is earned from activities within the Qualified Opportunity Zone.
Here are some of the IRS Filing Requirementsfor a Qualified Opportunity Fund:
- Annually file the IRS Form 8996, Qualified Opportunity Fund.
- Use Form 8996 to “certify the corporation or partnership is organized to invest in Qualified Opportunity Zone Property.”
- Use Form 8996 to “Report that [the property] meets the 90% investment standard of section 1400Z-2.”
- “Figure the penalty if it fails to meet the 90% investment standard.”
It’s important to keep in mind that your QOF investment’s value may decrease or increase over the holding period, just like any other investment you make.
Since Qualified Opportunity Funds are new options for investments and are federal income tax planning tools, it’s important to consider the risks similar to other investments. A few of these risks to keep in mind include:
- Market loss
- Liquidity risk
- Business risk
We will get into these risks further in a little bit. While risks are important to keep in mind, just remember the common maxim, “No reward is without the risk.” Focus on the word reward here. Let’s look at some of the advantages of investing in a Qualified Opportunity Zone.
Tax advantages of investing in a Qualified Opportunity Zone
When it comes to tax advantages, there are several ways an investor can financially benefit from a Qualified Opportunity Zone.
Deferring capital gains
According to Sec. 1400Z-2, deferral for any gain from an exchange or a sale is treated as a capital gain that is invested in a QOF within 180 days after the exchange or the sale.
According to The Tax Adviser website, a gain acquired in 2019 “is deferred until the earlier of the date on which such investment is sold or exchanged on Dec. 31, 2026, at which point the lesser of the deferred gain or the fair market value (FMV) of the property less the basis in the investment is included in income.
“Assuming tax rates do not increase, this gain deferral provides the financial benefit related to the time value of money, since the taxes on the gain being deferred are not due until some future date, either when the investment is sold or exchanged or when the deemed gain recognition happens on Dec. 31, 2026.”
Reducing capital gains
As an investor, you want to consider a long-term capital gain (LTCG) option. According to the American Bar Association, “there is a permanent reduction in part of the deferred LTCG from the original investment if the investment in the QOZ Fund is held for at least five years before [the] sale.
“If the QOZ Fund investment is held for 5 or more years, then the deferred gain will be reduced by 10%. If the QOZ Fund is held for 7 or more years, the deferred gain is reduced by 15%.
“Also, whenever the deferred gain is recognized, the tax basis of the QOZ Fund is increased by the gain that is then recognized.”
Although the tax is not indefinitely deferred, it can be deferred for seven years.
For example, in July of 2021, if you sell a zero-basis business for $10 million, which results in a $10 million capital gain, and you invest the entire gain in a Qualified Opportunity Zone Fund within the allotted 180-day timeframe (by November 1), then you will not have to claim the sale proceeds during the 2021 taxable year.
No appreciation tax
If the property remains in the Qualified Opportunity Fund for at least 10 years, then the cost basis of the property will be considered equal to the fair market value (FMV) on the date of exchange or sale of the property. Therefore, you would not be held responsible for any taxes on appreciation.
Now that we have discussed the federal income tax return benefits of a Qualified Opportunity Fund, let’s look at some additional positives and negatives of investing in Qualified Opportunity Zones.
Pros and cons of investing in Opportunity Zones
While the tax benefits are great, there are additional positives to making this kind of real estate investment.
- The biggest pro for investors is being able to defer taxes. Essentially, you can avoid paying capital gains taxes on real estate, stocks, and bonds.
- If you can afford to let your funds sit in a qualified opportunity fund for several years, your taxes will decrease. After 10 years they will be completely tax-free.
- You can take pride in knowing you are making communities better for those who can’t afford the higher costs of living, and the Opportunity Zone Frameworks (a set of guidelines) increases the likelihood of positive social outcomes in the communities as well.
- It’s more effective and beneficial to low-income family communities than previous programs. The number for current Opportunity Zones (8,700) throughout the United States greatly surpasses the numbers from past investment incentive programs.
While investing in a Qualified Opportunity Fund is great because of the tax incentives and the knowledge you are helping other people, you still need to keep in mind a few aspects that might not work out in your favor.
- Treasury risks. This type of investment is esoteric in the sense that it is geared towards and benefits a very narrow group of real estate investors who understand the high risk and possibility of an illiquid investment, since no active secondary markets exist for selling your securities.
- The returns from the funds may not be compelling enough because a fund typically charges an annual 2% interest fee.
- These funds are also subject to additional carried interests and fees, basically rendering the tax advantages from these funds useless.
- While capital gains from Qualified Opportunity Funds are tax-free, you need to keep in mind that if your real estate generates additional income from tangible property, such as rental properties, that income is liable to be taxed.
At the end of the day, you just have to keep in mind expectations that are realistic regarding your Qualified Opportunity Fund investment. Like all investments, QOFs are subject to market risks.
Since a Qualified Opportunity Fund may not be appropriate for all real estate investors, it is important to consider consulting with your tax advisor before you pursue this type of investment. They will be able to better help you determine if this opportunity is congruent with your risk profile and if it fits in with the diversification of your investments.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.