The rising income inequality and lack of affordable housing have compelled the government to create programs incentivizing people like investors to help in distressed communities. One of these programs is the Opportunity Zones. These areas, found in most states and territories of the U.S., provide tax deferrals and other benefits to any investor who pools their capital for the development of the opportunity zones.
Since the federal government established opportunity zones, many investors and developers have been excited about the prospect of helping disadvantaged communities and spurring a region’s development. Still, this investment vehicle must be approached with careful consideration and in-depth knowledge to help reduce risks and potentially increase returns.
At Realized 1031, we’re dedicated to helping investors understand what opportunity zones are and how they work. This article is our guide to help you get started and learn the pros and cons, requirements, and other pertinent matters regarding opportunity zones. Keep reading to learn more.
The History of Opportunity Zones
For decades, the real estate industry faced a disparity in investment and development. Companies and investors alike preferred to put their capital in affluent communities because this is where the highest potential for income occurs. This reality — along with several other factors — helped widen the gap between rich and poor communities. The ones that were already struggling saw even fewer opportunities to stimulate their economies.
In the bi-partisan Tax Cuts and Jobs Act of 2017, lawmakers established Opportunity Zones to help address the ongoing disparity. The core objective of Opportunity Zones is to encourage long-term investments in low-income urban and rural communities by providing tax incentives to investors. Each state identified these zones, using census data to determine which areas need the designation.
When a place gains the Qualified Opportunity Zone (QOZ) designation, the capital poured into it can help spur job creation, foster entrepreneurship, and drive economic development. Investors enjoy tax deferral and other benefits for dedicating their capital to an Opportunity Zone.
As of writing, there are around 8,700 QOZs in all 50 states plus U.S. territories like Puerto Rico and the U.S. Virgin Islands. This number is unlikely to change soon given how the U.S. Department of Treasury has already stopped certifying census tracts. To see the complete opportunity zone maps, check out the guide shared by the U.S. Department of Housing and Urban Development.
What Is an Opportunity Zone
An Opportunity Zone is a census tract — a specific geographic area — that is economically distressed. Some indicators include high unemployment rates, low-income levels, and a poverty rate of at least 20% within the population. States identify these areas, and the Department of Housing certifies them into QOZs. The primary goal of the designation is to drive capital to underserved areas that lack sufficient investment. This helps promote economic rejuvenation, rippling across the local population.
Opportunity Zones encompass a wide variety of areas. Within the 8,764 named zones, investors will find urban communities, rural neighborhoods, and suburban locations facing long-term economic challenges. California, Texas, and New York have some of the most Opportunity Zones.
Types of Investments in an Opportunity Zone
Investors who want to enjoy the tax and income advantages of Opportunity Zones have plenty of options as to where they can put their capital. We will discuss the process later. For now, let’s talk about the types of assets that you can help finance in QOZ.
Opportunity Zones Real Estate
The most common and popular type of investment in an Opportunity Zone is real estate. This includes new developments as well as extensive renovation of existing properties. Real estate projects can range from residential housing developments to commercial properties like office buildings, retail spaces, and mixed-use facilities.
Through these properties, developers can address issues like housing shortages and deteriorating properties. Plus, building or renovating buildings helps create new jobs. Once the commercial spaces are around, other employment opportunities in retail, hospitality, and manufacturing can emerge.
Opportunity Zones Businesses
You can also choose to pour capital into businesses operating within the Opportunity Zones. These investments play a major role in providing employment and contributing to the local economy. With the help of the pooled funds, these startups, small businesses, and expanding enterprises can make a considerable impact on the growth of the Opportunity Zone.
Opportunity Zones Infrastructure
Investments in infrastructure help an Opportunity Zone gain necessary structures and facilities that allow for economic development. These include essential public amenities and services, such as transportation networks, utilities, and community facilities. With these projects, the residents’ quality of life improves. With easier access to major roads, utilities, and public services, businesses have more incentive to operate in the Opportunity Zone. This creates a positive feedback loop that encourages additional growth in the private sector.
For most investors, the popular option is in real estate. However, many QOZ sponsors do offer diverse investment types. This practice helps create a more comprehensive approach to economic revitalization while potentially minimizing risks.
How Does an Opportunity Zone Work?
Investing in an opportunity zone is similar to how 1031 Exchanges work. You use the capital gains from selling the property and invest it into an Opportunity Zone. Unlike the 1031 Exchange, you’re not required to find a like-kind property. You can find any type of Qualified Opportunity Fund (QOF) and pool your money with other investors to defer taxes. Before we get into the exact methods, let’s define a few things.
Qualified Opportunity Fund (QOF)
The QOF — also opportunity zone funds — is the investment vehicle that brings together the capital for various investors. This fund has a structure like a corporation, managed by a professional investment management firm called the sponsor. The QOF must hold at least 90% of its assets in a QOZP.
Qualified Opportunity Zone Property (QOZP)
The QOZP is the property held by the QOF. This property can also be a stock, partnership interest, or business property. The unifying characteristic is that all these must have been acquired after December 31, 2017. As such, a property already in the Opportunity Zone will not qualify unless it undergoes “substantial improvement.”
Substantial Improvement
If a QOF acquires a property already existing in the Opportunity Zone, the IRS requires the fund to make substantial improvements. The IRS has clear guidelines about what these improvements are: the QOF must double the property’s adjusted basis — its current value — within 30 months after purchase. Otherwise, the IRS revokes the tax advantages of the investment.
Let’s look at an example. A QOF purchases or invests in a $15 million vacant retail building with the intention of modernizing it for new tenants. The QOF must invest at least $15 million more in capital for this space to satisfy the substantial improvement clause.
Investing in an Opportunity Zone: Aspects To Consider
The process of investing in an opportunity zone may seem complicated, but it can be broken down into a few areas that investors must keep in mind.
Creating or Joining a QOF
The first step to investing in an opportunity zone is the creation of the QOF. In most cases, the private equity firms or sponsors handle the administrative aspect of this stage. The investors’ role is to bring the funds that will be used as capital for the investment. The source is usually capital gains, allowing for tax deferral. However, using capital gains is not a requirement. The fund itself is open to any investor who wishes to contribute.
180-Day Deadline
The biggest consideration for investors is to select a QOF 180 days after the triggering event. This event is usually the sale of an asset, resulting in capital gains. By finding a QOF before the deadline, you meet IRS requirements and will be able to defer taxes.
QOF Requirements
As we mentioned above, a QOF must invest at least 90% of its capital into a QOZP. This property must be acquired after December 31, 2017, and by an unrelated party. In other words, none of the investors must have a previous vested interest or ownership of the QOZP. Generally, if the investor or entity has more than 20% ownership of the QOZP, then they are considered related parties and thus cannot contribute their capital gains to the QOF.
The IRS also requires that “substantially all,” or 70%, of the QOZP, must be within the Opportunity Zone for 90% of the holding period. The latter requirement may seem superfluous for assets like real estate given how these assets are unmoving. However, some QOFs can be used for funding equipment used for developing real estate and other types of infrastructure. As such, the requirement exists.
QOF Structure
A QOF can receive funds from a single investor or multiple. Then, the fund can have a corporate structure or a partnership. The IRS doesn’t really have a mandate on what the structure should be. However, the agency does require sponsors to complete IRS Form 8996 every year to remain recognized as a QOF.
Reporting the Deferral
Once you — the investor — enter the QOF, you must report the deferral to the IRS using Form 8949. All these steps and considerations can be complicated, so we advise working with a tax professional to ensure maximum accuracy and help you avoid any errors that may result in penalties.
How Money Can Be Made From an Opportunity Zone
The substantial improvements required by the IRS serve as a way to jumpstart the income-generation capabilities of the QOZPs. With enough capital, the QOF can develop the assets and begin cash flow. The QOF will then distribute the earnings to the investors as dividends or capital gains. The specific distribution method and frequency will depend on the fund’s investment strategy, performance, and the fund manager’s discretion.
Rental Income
There are several ways a QOF can generate cash flow. The first one is income from rental properties. If businesses or individuals lease a QOZP as housing or a place to conduct operations, the rent tenants pay becomes income for the QOF.
Business Investments
A QOF can earn income by taking a percentage of the business that it funded using the pooled capital. Acquiring ownership stakes in companies operating within the zone is another way to earn income from business investments.
Asset Appreciation
As QOZP undergoes considerable development, there is the potential for asset appreciation. Once the holding period is over and the QOF sells the building, the value could be higher than the original purchase price. As such, there would be capital gains.
Significant Tax Deferral Through the 10-Year Rule
There are ways that could result in a significant tax exemption on capital gains (from the initial investment) for investors. This is the 10-year rule, wherein the investor holds the QOF investment for a decade or more. This benefit also extends to gains from the sale of assets held by the QOF. Once you complete the decade, all capital gains from the original asset’s appreciation as well as depreciation recapture will go away.
Tax Benefits of Opportunity Zone Investing
There are three ways that investors can enjoy potential tax savings.
1. Tax Deferrals Through 2026
As we mentioned above, capital gains taxes will remain deferred when you invest the funds into a QOF. You can enjoy this benefit as long as you’re able to invest within the prescribed 180-day period. The only time you’ll need to pay is when either of these two events happens.
- December 31, 2026: This is the latest date on which the deferred tax must be paid. The tax will be due when the taxpayer files their 2026 tax return in 2027.
- Sale of the QOZP: Once the sponsor sells or exchanges the property before December 31, 2026, the deferred gain becomes taxable again. The same thing happens if the investor sells or exchanges your interests in the QOF before the mentioned date. As long as you hold your capital, you won’t have to pay taxes until the end of 2026.
2. Step-up in Basis
This benefit is no longer possible for new investors since it came to an end on December 31, 2021. Still, we want to mention the step-up in basis tax benefit as another one of the incentives that caused a stir among investors when Opportunity Zones were still in their infancy. Thanks to this provision, investors funneling capital gains to the QOF for five years received a 10% step-up in basis. Those who continue doing so for seven years enjoy 5% more. If you were able to join before the end of 2021, you could’ve eliminated taxes on up to 15% of your capital tax gains.
There is a possibility that this benefit will return. The Opportunity Zone Transparency, Extension and Improvement Act proposed in April 2022 outlined the extension of the Opportunity Zone deadline until December 31, 2028. The act hasn’t been signed into law yet. If it is signed, it could also extend the deadline for the step-up in basis provision. The bill has been reintroduced during the latter half of 2023, but it’s expected to remain on hold until 2025.
3. Potentially No Taxes on Property Appreciation
As we mentioned above, all capital gains from the QOZP during the holding period will remain non-taxable during the 10-year holding period. How so? The QOZP’s cost basis after the period will be equal to the fair market value on the date of the sale. This provision means that technically, the QOF didn’t make any capital gains even though it’s appreciated. The IRS added this benefit to entice even more investors to put their capital in the distressed communities.
Opportunity Zone Advantages
When you invest in an Opportunity Zone, you can enjoy various benefits. The most appealing ones would be the tax benefits we listed above, which help you save on capital gains taxes and potentially bring in additional income from the QOZP or other assets managed by the QOF. However, tax advantages are not the only perks you can enjoy when investing in an Opportunity Zone. Here are other benefits of this investment opportunity.
Supporting Economic Development in the Country
Even though the U.S. is considered a first-world country, there are still plenty of people who are struggling. The increasing divide between income classes is making it harder for these communities to grow economically. Disadvantaged individuals and families have little opportunities to find stable employment. They also have limited access to basic needs because their neighborhoods remain underdeveloped.
Choice of Active or Passive Role
Whether you want more control over the investment or not, QOFs give you the option based on your preference. Those who want to take on more passive roles can work with private equity firms, which serve as the sponsors. These organizations take on the administrative and operational aspects of the QOF, such as finding a QOZP, hiring third-party property management teams, and distributing the earnings.
Investors who take a more active role can have more control over the management of the QOZP. They can decide what changes to make to the QOZP, which property management team to hire, etc. For this structure, you have the choice to enter a partnership with a sponsor or create your own QOF.
More Diverse Portfolio
As we highlighted above, there are plenty of investment types available in Opportunity Zones. These can be real estate property, businesses, or infrastructure projects. This large variety creates opportunities for investors to diversify their portfolios. A QOF can pour capital into several investments, not just one. This diversification can help mitigate risks and potentially enhance returns.
Alignment With ESG Investing
For socially conscious investors, QOFs provide a means to align their investment strategies with environmental, social, and governance (ESG) goals. Putting capital into Opportunity Zones lets you contribute to meaningful social change, addressing economic disparities and fostering growth among disadvantaged communities. By achieving your ESG goals, you can enhance your reputation and fulfill social responsibility objectives.
Stronger Community Ties
If you belong to a location near or within an Opportunity Zone, investing in a QOF can enhance your community engagement. You may get the chance to work closely with community leaders, local business owners, and residents. With stronger ties, you gain a deeper knowledge of the community’s needs. This understanding helps you tailor investments that generate the most significant impact on the Opportunity Zone, especially if you’re taking on a more active role in the QOF.
Opportunity Zone Disadvantages
Like other types of investment vehicles, QOF and Opportunity Zones come with inherent risks and challenges. Aside from the fluctuations in the market that affect property values and rental income, here are some of the most considerable risks that are unique to these types of investments.
Vague Regulations
There is a lot of regulation uncertainty when it comes to QOZs. These investments started with a lot of vague provisions, subject to interpretation by each state. It was only the second round of provisions and rules released in April 2019 that gave clarity to a few things, such as the 90% rule on “substantial improvement.” New updates announced in December 2019 were the last, but there are still some vague aspects that some QOFs and investors may find confusing.
Future changes in tax laws or Opportunity Zone regulations could impact the anticipated benefits. Investors must be prepared for the possibility that the regulatory environment may change in ways that could affect their investments.
Dynamic Capital Pipelines
QOFs have a lot of moving parts, from deal introduction to closing. The capital pipeline could experience lots of changes thanks to the number of players involved. As such, it’s important to remain updated about the latest happenings within the fund. Having a team that stays on top of these changes allows you to make more informed decisions during critical moments.
One way to help mitigate this risk is the 31-month working capital safe harbor given to QOZ businesses. This provision allows the QOF to hold the funding for more than two years before it’s put to work, serving as a buffer for any unforeseen challenges.
Possibly Crowded Exit
The 10-year holding period won’t be over until 2028 or 2029 for most funds. However, the tax deferrals for the initial capital do end on December 31, 2026. Upon this deadline, many investors may no longer find any incentive to stay with a QOF. Many may decide to sell their interest, resulting in a rush of exits. This possibility could drive down the value of the QOZPs and other assets. The likelihood of this scenario is still low, but it’s a possibility that investors should keep in mind.
Rising Value of Lands
Along with the rising popularity of Opportunity Zones come higher land values in the eligible census tracts. This trend could create a barrier for small-time investors and operators who may not have enough capital to purchase valuable properties. This challenge may not be as apparent to large operators since these usually have enough capital to invest in institutional-grade assets.
Non-Conforming States
All states in the U.S. have Opportunity Zones, but there are some that do not follow the tax deferral amendments outlined in the Tax Cuts and Jobs Act. This nonconformity happens because of differing methods for computing income. California, North Carolina, and Mississippi are three non-conforming states. In such cases, you still defer tax liability on a federal level. However, you need to make tax payments to state revenue departments. As such, you’re not completely deferring taxes if you live in these states.
Resistance From Communities
One criticism about the Opportunity Zone program is how it could encourage gentrification. This concept is the rapid development of neighborhoods into developed communities. This may not sound bad on paper, but the quick change could increase living costs and property values, making the area less accessible to the original residents. As such, Opportunity Zone investments may be met with resistance from communities that fear the negative effects of gentrification. Such fears are not unfounded, and they could lead to an uncooperative population that creates social tension. As such, engaging with the local communities becomes even more crucial to ensure that investors can gain support and address the misgivings of the local residents.
Other Risks of a QOF
Risk Factors
Investment Risk: Investing in QOZs can be high risk due to the nature of the areas targeted for development, which may have economic, social, and infrastructure challenges.
Market Risk: The value of investments in QOZs can be affected by broader market conditions, including economic downturns, changes in interest rates, and political or regulatory changes.
Tax Implications
Deferral of Capital Gains: While investing in QOZs allows for the deferral of capital gains tax, it is crucial to understand the conditions under which this deferral applies and the timelines involved.
Tax Benefits Timing: The tax benefits are contingent on holding periods (5, 7, and 10 years). Selling investments prematurely can negate these benefits.
Changes in Tax Laws: Future changes in tax laws could impact the benefits of investing in QOZs.
Regulatory Considerations
Compliance Requirements: Investors must ensure that the fund they are investing in complies with the specific requirements of the Opportunity Zone program to qualify for the tax benefits.
Fund Reporting: QOZ funds have specific reporting requirements to the IRS, and failure to comply can affect the tax benefits.
Investment Strategy
Due Diligence: Thorough due diligence is essential to assess the viability and potential return on investment. This includes evaluating the fund manager's track record, the specific projects being invested in, and the overall economic outlook of the Opportunity Zone.
Diversification: As with any investment, it is advisable not to concentrate too heavily in a single type of investment or geographic area.
Legal and Financial Advice
Professional Guidance: Consulting with tax advisors, financial planners, and legal professionals is critical to fully understand the implications and ensure the investment aligns with overall financial goals.
Mitigating the Risks: Due Diligence Before Entering a QOF
Due diligence is critical to mitigate the challenges we outlined above. Follow these steps to help you weigh the risks and rewards of an Opportunity Zone investment.
1. Assess the Sponsor or QOF Manager
This tip applies to those who want to join a QOF instead of creating their own. Evaluating the track record of the manager is critical because of their overarching role. To help you determine if the manager can deliver, check their track record, licenses or accreditation, and reviews from previous clients.
2. Evaluate the Contractor or Developer
The QOF manager works with an operator who will handle the execution of the project. A competent contractor will have processes and resources to ensure that the QOZP has a high potential to generate income. If this information is available before you sign into a QOF, make sure to evaluate the partner contractor and their past performance. Investigate their previous projects to understand their capability to deliver on time and within budget.
3. Compliance With IRS and State Regulations
The IRS and your respective state revenue department have rules and regulations that the QOF and its partners have to follow. As such, it’s critical to determine if the prospective QOF is following these rules to ensure that the IRS won’t strip away the tax deferral benefits.
4. Assessing Community Impact
Some communities will resist projects they deem harmful to their members. As such, it’s also important to evaluate how a QOF project will impact the local community. The ideal investments are ones that provide substantial benefits to the community without pushing out the residents. Investments that create job opportunities or improve infrastructure are generally more acceptable compared to high-end, new-build properties that would only usher gentrification.
5. Have an Exit Strategy
Given the 10-year holding period for maximum tax benefits, it may be tempting not to think about your exit strategy now. However, understanding your options this early on can help you choose the strategy that maximizes your tax benefits.
Who Can Invest in a QOZ?
We’ve mentioned above that anyone interested in a QOZ can invest their capital into a QOF, not just those who want to defer taxes. However, this lack of restriction is much harder to put into practice than in theory. For starters, many private equity firms put a minimum on the capital an investor must commit to join the QOF. Plus, most sponsors usually work with accredited investors. These individuals have certain characteristics that make them distinct in the eyes of finance regulation agencies, such as the Securities and Exchange Commission (SEC).
Accredited investors must have the following.
- Annual income exceeding $200,000 in the previous two years and is expected to earn the same or higher in the current year.
- A net worth exceeding $1 million.
- Assets under management must be worth $1 million or higher, excluding the value of the investor’s private residence.
If you do satisfy these rules, there is another barrier that limits who can invest in Opportunity Zones. Since QOFs are considered securities, the sponsor needs to register the funds with the SEC. Upon doing so, the fund becomes unavailable to the open market and can only be available to broker-dealers or investment advisors. These firms only work with accredited investors, so those without the designation may have a harder time investing in a QOF.
What are the options for investors who don’t meet the accreditation requirements? There is one approach: creating your own QOF. This step is not easy, and it involves adhering to stringent rules set by the IRS. You’ll need to create a partnership or corporation structure for the fund, which is solely dedicated to investing in a QOZP — the 90% requirement. Plus, you have to ensure that the capital doubles in 30 months to satisfy the “substantial improvement” clause.
Given these requirements, it may prove difficult for small-time investors to leverage the tax benefits of Opportunity Zones. Thankfully, there are other possibilities, such as 1031 Exchange or a deferred sales trust. You can consult with our team to learn more about these other options.
The Future of Opportunity Zones
More and more investors are becoming aware of the benefits and opportunities in QOZs. This increase in knowledge may also increase the number of people who want to participate, leading to more capital in the economically distressed census tracts.
The future is promising, but the coming deadline on December 31, 2026, looms closer. This timeframe may hold back some investors. Uncertainty also comes in the regulation of Opportunity Zones. The non-conforming states may yet pass laws that enhance or limit the appeal of QOZs. As such, investors must keep an eye out for these changes and adapt as needed.
Final Thoughts on Opportunity Zones
Since the Opportunity Zone program began in 2017, it has become not just a tool for investors to defer taxes and gain income but also a way to help distressed communities develop. As investors pool capital into the QOF, it gains resources to build new properties, start new businesses, or construct infrastructure for public services. These projects have a high potential for earning revenue. At the same time, the original capital invested by each investor remains tax-deferred until the end of 2026. All these benefits make Opportunity Zones an attractive option for those who want to help communities while earning at the same time.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.irs.gov/credits-deductions/businesses/opportunity-zones
https://www.investopedia.com/taxes/trumps-tax-reform-plan-explained/
https://www.wellsfargo.com/the-private-bank/insights/planning/wpu-qualified-opportunity-zones/
https://www.irs.gov/forms-pubs/about-form-8996
https://www.congress.gov/bill/117th-congress/senate-bill/4065
