Qualified Opportunity Zones originated in the Tax Cuts and Jobs Act which became law in December of 2017. The relevant portion of the legislation allows investors to defer taxes on capital gains if they reinvest the proceeds into 8,700 designated areas called Qualified Opportunity Zones, which the federal government has highlighted as economically challenged.
While federal in origin, state and local agencies operate the program, and each state has the autonomy to establish individual rules and governance for its QOZ program. However, each Qualified Opportunity Fund (QOF) must invest in property within a QOZ and substantially improve the asset's value within thirty months. To meet the "substantial improvement" requirement, the QOF must double the property's adjusted basis in the QOZ (not including the land value) within that 2.5-year schedule.
That requirement is generally considered aggressive, which makes these investments risky. Investors considering QOFs should conduct careful research before committing. You should have confidence in the fund manager's expertise before deciding to invest in a project and gain access to enough information about the prospective QOF projects to make a reasonable decision.
There are semi-blind QOFs, which seek to raise a specific level of capital before determining which Zone projects to pursue. The taunted advantage is that since they raise the money before seeking property, they can acquire and close quickly, improving their odds of meeting the 30-month deadline for success. There may be validity in that approach, but it certainly heightens the level of trust you as an investor must have in the fund’s management.
Can a Park Be Part of the QOZ?
Developing parkland would not be a logical investment for a QOF. The rules do prohibit investment in certain businesses that could be developed on park type land, including so-called “sin” operations:
- Golf courses, country clubs, hot tub parks, race tracks, and gambling facilities
The types of development include a wide range of projects, including housing and commercial developments. Among the popular targets are undeveloped land, empty buildings, and older properties with fewer amenities. The reason is that these assets may be able to meet the improvement metrics quickly.
Does it Make Sense to Invest in a QOF?
The advantage to the investor in investing in a QOF is the ability to defer paying the tax on certain eligible capital gains until December 31, 2026, if certain conditions are met and adequately reported to the IRS. The length of time that an investor maintains the investment in the QOF determines the amount of benefit that they can potentially receive:
- A five-year investment can yield an increase in your basis of 10% of the deferred gain.
- A seven-year investment can increase the basis by an additional 5% of the deferred gain.
However, as noted above, Qualified Opportunity Funds are considered risky investments. QOF projects have this reputation partly because they are, by definition, located in areas designated as economically disadvantaged and in need of capital. In addition, many of the funds created to invest in these zones are started and managed by leaders with little proven experience. The investor may not be able to obtain as much information as they would typically prefer to have to support a prudent investment decision.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with the transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
