The information and write-ups about the Opportunity Zone program tend to focus on two things:
- Economic revitalization efforts for the Qualified Opportunity Zones (QOZs)
- Deferred taxes for investors who put their capital gains into Qualified Opportunity Funds
Both of these factors can offer great incentives to QOF investors. But how do QOZs actually make money?
How QOFs Operate
With all the QOZ focus on tax breaks and economic revitalization, it’s important to remember that Qualified Opportunity Funds are—well, funds. They’re investment vehicles that can offer potential benefits, like a specific return on investment, annual returns, or income. They’re also similar to other real estate funds in that they pool money from investors, then use it to buy properties in federally designated QOZs.
But an important requirement for any Qualified Opportunity Zone Business Property (QOZBP) asset is the “substantial improvement” clause. Specifically, the QOF has 30 months after purchase of/investment in a particular QOZ property to make improvements. Specifically, the QOF is required to double that property’s adjusted basis. Or else the IRS can step in and strip away any potential tax advantages of that investment.
For instance, let’s say a QOF buys a vacant office building for $10 million with an eye toward converting it into workforce housing. The QOF has 30 months from the date of closing to invest an additional $10 million to convert and upgrade that property into residential housing. This would satisfy the “substantial improvement” requirement.
These improvements can help QOF assets make money with the following:
Prospective cash flow. Converting a vacant building into one for tenants can mean rent. And rent can lead to cash flow. This is true, whether that building is held by a QOF or other real estate fund.
Possible asset appreciation. Moving a building from vacancy to stabilization can help improve its value. This could mean that the QOF might sell that building at a higher value than its original purchase price, generating a capital gain. As a reminder, if the QOF investor holds their position in the fund for 10 years or longer, they won’t pay taxes on that capital gain.
But Caveat Investor
QOFs are investments. As such, they offer substantial risks to participants. Potential returns aren’t guaranteed from any kind of real estate investment, let alone those involving Qualified Opportunity Zones. And just like any real estate fund, issues like property location and sponsor track record will have a bearing on how much might be generated or returned.
Because of this, due diligence is important when considering a QOF investment. Study the location. Be sure the fund manager and/or sponsor has experience with QOZ property improvements and regulations. Also check with your financial planner, attorney, or tax expert when considering such an investment.
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. It should also not be construed as advice meeting the particular investment needs of any investor.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
Hypothetical examples shown are for illustrative purposes only.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
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.