Real estate investors are discovering that investing in opportunity zones provides a new alternative to deferring–and in some cases completely eliminating–capital gains tax liability.
Traditional Section 1031 exchanges can still be used to defer capital gains, but sometimes it’s difficult finding a replacement property when there’s so much competition for commercial real estate. Let’s take a closer look at what opportunity zones are, how they work, and how to invest in the Qualified Opportunity Zone program.
Opportunity Zones Were Created in 2017
The Qualified Opportunity Zone (QOZ) program was created in 2017 when Congress passed the Tax Cuts and Jobs Act. By offering real estate investors significant tax benefits, the program aims to boost investment and economic growth in low-income areas throughout the United States and U.S. territories.
Real estate investors can reduce their capital gains tax liability by investing realized capital gains in QOZs. Unlike a 1031 exchange where future gains from the property being exchanged into are taxed, additional profits made from investments in Qualified Opportunity Zones are capital gains tax-free.
Opportunity Zones Offer Investors Significant Tax Benefits
There are two significant tax benefits of investing capital gains in Qualified Opportunity Zones:
- By investing realized capital gains into a Qualified Opportunity Fund (QOF), investors can reduce their taxable capital gain by 10% in five years and an additional 5% in seven years, and can be deferred for up to a total of nine years.
- Additional capital gains from investments held in a QOF for at least 10 years are completely excluded from capital gains taxation.
Opportunity Funds Are Used To Invest In OZs
Opportunity Funds – or QOFs – are the investment vehicles designed by the Internal Revenue Service (IRS) used to invest in Qualified Opportunity Zones. Qualified Opportunity Funds are defined by the IRS as U.S. corporations or partnerships that invest 90% or more of the Fund’s holdings in one or more Qualified Opportunity Zones.
Opportunity Funds can invest in Opportunity Zones in three different ways:
- Real estate or business property within a Qualified Opportunity Zone,
- Partnering with a business that operates within a QOZ,
- Buying stock in a business that does all or most of its business in a Qualified Opportunity Zone.
Four Additional Benefits Of Investing In Opportunity Zones
There are four other major advantages to investing in Opportunity Zones that aren’t provided by 1031 tax-deferred exchanges, or the existing empowerment zones and renewal communities programs authorized by Congress.
- Only the capital gain amount needs to be reinvested, not all of the proceeds from the asset sale.
- Capital gains made from sales both outside and inside of Qualified Opportunity Zones can be invested in QOZs.
- Investments don’t have to be ‘like kind’ – capitals gains from stocks, cryptocurrencies, precious metals, and more – can be invested in an Opportunity Zone.
- Syndicators can create Opportunity Funds to target a variety of investment opportunities within Qualified Opportunity Zones.
Where To Find Qualified Opportunity Zones
There are about 8,700 Qualified Opportunity Zones approved by the U.S. Treasury and the IRS. QOZs are in every state in the U.S., Washington D.C., and in U.S. territories such as Puerto Rico, the Virgin Islands, and Guam.
In addition to deferring and potentially permanently excluding capital gains from taxation, investing capital gains in Qualified Opportunity Funds help reduce investment risk through geographical diversification.
How To Use Opportunity Zones To Defer And Exclude Capital Gains Tax
Mary – a fictitious real estate investor – purchased an office building in the Great Hills submarket of Austin eight years ago. The demand for commercial office buildings in Austin TX has been extremely strong and Mary decides to sell. When her deal closes, she’ll have $750,000 in profit subject to capital gains tax.
By investing her $750,000 of capital gains in an Opportunity Fund:
- After 5 years her taxable capital gain would be reduced by 10% to $675,000,
- After 7 years her taxable capital gain would be reduced by another 5% to $637,500,
- After 10 years, any appreciation generated from the initial $750,000 invested would be free from any capital gains taxation.
After nine years Mary would have to pay the capital gains tax on just $637,500 even though her original investment was $750,000. However, any profit earned from her $750,000 invested would be free of capital gains tax, provided that she keeps the money in a Qualified Opportunity Fund for at least 10 years.
Some Common Questions About Investing In Opportunity Zones
How are Qualified Opportunity Funds created?
Currently, there are no laws that limit who can form an Opportunity Fund. There are three guidelines that all Opportunity Funds must follow:
- The entity must be formed to invest in property located within Qualified Opportunity Zones,
- At least 90% of the Fund’s investments – including real estate, stocks, or partnership interests – must be within an Opportunity Zone,
- The Fund must use IRS Form 8996 to self-certify that it meets the 90% asset requirement.
What are the main differences between a 1031 tax-deferred exchange and investing in an Opportunity Zone?
Firstly, Opportunity Zones allow investors to defer and reduce their original capital gains amount and generate profits from the initial investment that are free from capital gains tax. Secondly, unlike a 1031 exchange where real estate investors must re-invest all of their sales proceeds, only the capital gain from a sale must be invested in an Opportunity Zone.
What is the time limit for investing capital gains in a Qualified Opportunity Fund?
Real estate investors have 180 days to re-invest their capital gains into a Fund.
Are investments in Opportunity Funds limited to just capital gains?
No, investors may invest more money than the amount of their capital gains if they choose to. The investor would make two investments: 1) Capital gains to be reduced, 2) Additional investment not related to the taxable capital gain.
The IRS plans on holding public hearings on the proposed regulations for the Qualified Opportunity Zone program and will then issue further rules.
However, one thing is clear: using Opportunity Funds to invest in Opportunity Zones offers real estate investors a new way to defer capital gains and give back to the community by investing in economically under-served areas across the U.S. and its territories.