Are Opportunity Zones the Greatest Tax Break of This Generation?
The information below is for informational purposes only and does not constitute accounting or tax advice. Persons receiving information through this article should not act or rely upon this information without consulting their own accountants or tax advisors.
The rules for these investments are complex it is advisable to seek professional guidance with a CPA, Accountant, & Real Estate professional before proceeding.
When looking at property investments, especially in the area of Commercial Real Estate, one thing that must always be taken into account is how long or short an individual's or company's holding time is for their investments. Investors want a solid return for their patience long term, unfortunately tax liabilities seem to stand in the way of many well thought out investment plans. The question then becomes "What is the optimal investment strategy to minimize tax liability and maximize appreciation?". The Qualified Opportunity Zone Program added to the Federal tax code by the Tax Cuts and Jobs Act on December 22, 2017 gave investors precisely that, however it wasn't until until June 14, 2018, that the Treasury department certified zones in all 50 states, Washington, D.C., and U.S. territories, and it then took until October 19th 2018 for the IRS to release the proposed regulation taxpayers were in need of for direction. Many people I have spoken with seem to be confused on this program and seem to have some but not all of the information, and I believe that to be directly due to the staggered roll out of program information.
This Opportunity Zone Program gives investors the ability to roll over profits from the sale of capital assets such as Real Estate or company stock into areas that have been deemed "Opportunity Zones". Qualified Opportunity Funds or QOF's's may invest in Real Estate or Businesses located in these approved zones and allow you to delay paying capital gains on the rolled over profits through December 31st 2026. (You may also transfer property other than cash as an investment into a QOF, however a transfer of non cash property may result in only part of the investment being eligible for tax benefits)
The Opportunity Zone tax benefits have been structured in a tiered approach as follows; if an investor retains an Opportunity Zone investment for at least 5 years, 10% of the initial investment is excluded from being taxed. After seven years this increases to 15%, and after 10 years you can pocket any money you earn from the zone investment TAX FREE. This cannot be stressed enough! If held for 10 years, that investor can pay ZERO capital gains tax on the new investment in the fund. I believe that to be the real reward here: if you hold your investment in these opportunity zones in a QOF, you essentially pay no tax on your returns, which could lead to a 25-40% increase in your annualized return! These deferred taxes on capital gains and a potential tax-free profit in the future creates an incredible combination of financial incentives for beginner to advanced investors as well as large developers and commercial users.
Opportunity Zones are similar in some ways to 1031 like kind exchanges (1031's allow investors to defer taxes on gains from the sale of a property by reinvesting the proceeds from the sale in another property within 180 days). A major difference is 1031's do not allow for you to permanently exclude any portion of your profit from taxes, which Opportunity Zones as we now know allow for investments held for at least 10 years in a QOF. Another difference that is important to note is where 1031's require an intermediary to hold the funds until the next investment is in place, Opportunity Zone Funds do not need to be kept separate, you just need to file IRS Form 8949 with your income taxes to report your investment to the IRS.
To utilize these tax benefits you must invest capital gains into vehicles known as Qualified Opportunity Fund's, which aggregates money from investors and uses it to acquire and improve properties or businesses in opportunity zones within 180 days of the sale of a capital asset. You may choose to work with an existing fund who's portfolio fits the area and type of property you are interested in putting your money into, or form your own fund. One major confusion I have been hearing is that you must invest as much into the property as you pay for it however the tax code states it must be "substantially improved". As clarified in the recent Revenue Ruling by the IRS, the term substantially improved means that taxpayers must double their adjusted basis in the property after purchase and during any 30-month period that they hold their qualified opportunity zone property. The additions to basis must exceed the adjusted basis in the property at the beginning of such 30-month period. Land is excluded from the adjusted basis calculations..
As mentioned you may set up your own QOF, a Qualified Opportunity Fund can either be set up as a partnership or corporation you must self certify by filing IRS Form 8996, with the companies Federal income tax return. Also an LLC can be an Opportunity Fund as long as they are treated as a partnership or corporation for federal tax purposes. The fund is required to hold at least 90% of its assets in the qualifying Opportunity Zone area.
Another side of Opportunity Zone investing is investing in businesses which many have yet to breach into. The guidelines for a business a QOF can invest in is; they must perform at least half of their services in a zone, pay half of their wages in the zone, or generate half their income from a mix of property and management functions in a zone. There are some businesses deemed "sin business" that are disqualified from Opportunity Zones they are; any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or facility used for gambling, and any store the principal business of which is the sale of alcoholic beverages for consumption off the premises. The attraction to business investing however has remained low due largely to the unknowns. With Real Estate in 10 years your building is in the same location as the day you purchased, and if it is giving good returns in the first 5 years the chances are it will continue to give positive returns for 10 years. Whereas with a business in 10 years it could be acquired, move to another location, go public, completely change their business model, or just downright fail. Something to take into consideration in regards to risk exposure when looking at Real Estate vs Business investment is while a Real Estate Fund can be set up for a single project most Business Funds need to diversify their investment over several companies to offset any losses should any of the companies fail.
As investors get more comfortable with Opportunity Zone Investment I believe we will see the Real Estate investment side quickly saturated by investors as the guidelines are simpler and the deals are easier to analyze. After these investors have taken the premium investments off the table more and more will turn to the business side of the Opportunity Zones. Business investors and Real Estate investors in QOF's can and will work in tandem to secure offices, warehouses, or manufacturing space for a growing company to lease out and benefit investors on both the Real Estate and Business side by providing leasable space to growing businesses both held in QOF's. Inevitably these two sides will come together as property owners need tenants and companies need a business location providing dual benefit.
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