How Qualified Opportunity Zone Investing Works
Bill and Linda owned a machine shop in Durham, North Carolina, for 32 years. The business had belonged to Bills father, who had long since retired.
Bill and Linda were both 62 years old and had just begun to think about retirement. Their two grown children had taken positions in Texas, and Bill and Lindas first grandbaby was soon to be born.
Selling the Business
Conversations kept coming up about selling the business and moving to Texas to be closer to the kids. The business was a grind, and Bill and Linda reasoned that being closer to the kids was a sound move as they aged, and they were certain they didnt want to miss seeing their grandbabies growing up.
As luck would have it, no sooner than Bill put the word out that they may be selling, three potential buyers expressed interest, and one buyer provided them with a letter of intent and a written purchase offer of $2 million.
Bill and Linda had been working with their CPA, Ed, for 32 years and decided it was time to bring Ed into the conversation. First, Ed said he would need a couple of days to run the calculation as to what the tax bill might look like. Then, he mentioned something about basis, depreciation, net investment income tax, capital gains taxes, and other considerations he would need to examine to determine the impact of taxes upon the sale were it to go through.
The Burden of Selling a Business
In Search of a Solution
Qualified Opportunity Zones
Courtesy of Daniel Goodwin
Understanding Qualified Opportunity Zone Funds
A Qualified Opportunity Zone Fund is an investment vehicle that is organized by corporations and partnerships. Investors can do this by filing Form 8996. The intention behind all Qualified Opportunity Zone Funds is to invest in real estate or develop businesses in areas that are called Qualified Opportunity Zones. In order to meet this requirement, this fund must hold at least 90% of its assets in Qualified Opportunity Zone properties.
Like other investments, these funds can increase and decrease in value during the holding period. Theres also a possibility that the investment can yield a cash flow. However, since the purpose of the investment is to help communities gain traction, all proceeds should be reinvested to help increase growth in these communities. But, once property improvements are done, investors can sell the property to a third party for cash flow.
Currently, its challenging to assess the level of risk this investment yields. Because the IRS and U.S. Treasury are still figuring out how these funds will perform over time, its hard to establish a risk level. Some potential risks of this investment may include liquidly risk, market loss and business risk.
The purpose of a Qualified Opportunity Zone is to revive a community that is facing economic stress. The 2017s Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to offer tax benefits to private investors who invest in these communities.
Qualified Opportunity Zones: What Investors Should Know
- The 2017 Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to provide a tax incentive for private, long-term investment in economically distressed communities.
- Investors in these programs are given an opportunity to defer and potentially reduce tax on recognized capital gains.
- Tax savings are only available when investors retain the investment in the Qualified Opportunity Fund for the time frame stated.
What this may mean for you:
- If you are facing a significant tax liability as a result of capital gains, investing in a Qualified Opportunity Fund may be worth exploring, provided you invest within a prescribed amount of time.
Recommended Reading: How Can I Start Investing In Real Estate
What Are Opportunity Zones
The Opportunity Zone program, created by the Tax Cuts and Jobs Act, offers attractive tax incentives to investors. In 2018, all 50 states, the District of Columbia, and five U.S. territories designated certain areas as Opportunity Zones, or economically distressed regions that could benefit from long-term investment.
Choosing Qualified Opportunity Zone Funds In 2021
Thanks to the multiple tax benefits offered by the US government, opportunity zone funds have received widespread attention amongst investors. Since its inception in 2017, qualified opportunity zones have raised an estimated $75 billion in capital through its 219 plus available qualified opportunity zone funds.
While the tax savings associated with investing in qualified opportunity zone funds are appealing, choosing the right qualified opportunity investment funds is challenging for many investors. If you are new to the world of QOZ funds, then you can read our articles on qualified opportunity zone funds to learn more about this unique investment vehicle.
Recommended Reading: Morgan Stanley Access Investing Account
Ways To Investopportunity Zone Funds
Opportunity Zone Funds, or Qualified Opportunity Funds , are partnerships or corporations with the sole purpose of investing in Opportunity Zones. Rather than putting your money directly onto QOZs, you invest in the funds, which then funnel your capital gains into QOZ projects.
QOFs typically fall into one of two categories:
Identified funds have specific QOZ projects already in the works, or under contract. The advantage to this fund structure is that you know upfront what project or projects are being financed and developed. These funds are more transparent, and you can actually visit the development sites.
Semi-blind funds focus on raising capital first, then finding likely projects on which to spend that money. While these funds arent as transparent as their identified counterparts , they have a higher level of liquidity. This can help lead to a quick acquisition and closing.
As is the case with other finances or funds, its essential to perform due diligence on QOFs prior to investing. Some of the details to examine include the following:
Track record. Because the Opportunity Zone program is still relatively new, complete information about a QOFs performance might not be immediately available. In this situation, you can examine the Sponsors previous projects, risk mitigation efforts, returns, and other pertinent information.
Investment Grade Corporate Bonds
According to the Federal Reserve the current yield on investment grade corporate bonds is 3.87%.
These rates are much higher than what you can get on bank savings vehicles, US Treasuries, or municipal bonds, because they are issued by individual corporations and considered higher risk.
You can invest in individual issues of corporate bonds through popular investment brokerage accounts. But for smaller investors, it will be better to do it through funds, like either ETFs or mutual funds.
Just as is the case with municipal bonds, investing through funds will give you an opportunity to diversify a small investment across many different bond issues.
You can investigate which funds offer the best blend of safety and interest rate return. But also carefully consider the average term of bonds held in any fund.
The longer the average term of the bonds held, the greater the risk that rising interest rates will cause the principal value of the bonds to drop, causing you to lose money on the investment.
If you do invest in investment grade corporate bonds, be careful not to confuse them high-yield bonds.
Once commonly referred to as junk bonds, they pay higher yields than investment grade bonds because theyre lower quality, and more likely to default.
They are securities rated less than Bbb or Baa.
Also Check: Self Directed Ira Business Investment
How Does Investing In Opportunity Zones Work
The Opportunity Zone Program does include both commercial and residential real estate. However, you must invest your capital gains through what is known as a Qualified Opportunity Zone fund within 180 days in order to realize the tax benefits. The IRS has released specific guidelines for what a Qualified Opportunity Zone Fund is, with plans to release more regulations by the end of this year. However, the basics of these Opportunity Zone Funds are as follows:
These funds invest in Qualified Opportunity Zone Property. In terms of real estate, the qualified property must be a business property which can include multi family real estate that is operated as a rental business. Because the purpose of the investment in the Qualified Opportunity Zone Property is to improve the community, the capital must go towards the development of new real estate property. Alternatively, the investment can be put towards the rehabilitation of an existing property. The cash investment for rehabbing property must be more than the price paid to buy the property. There is also a set time for the rehabilitation or development- it must be completed within 30 months of the purchase.
How To Find An Optimal Qoz Investment Opportunity
To get the most of your investment, you should look for well-managed QOFs that offer low-risk and high-return.
Invest in well-managed QOFs
QOFs are managed by QOZ sponsors, which are entities established to operate and oversee the inner-workings of a fund. The ability of a sponsor to properly manage the fund will have a significant impact on its performance.
Since the Opportunity Zone program is relatively new, many sponsors will be using their past experiences in similar types of investments and applying them to the management of the QOFs.
As such, you should look for sponsors/managers that have an established track record in the sub-markets or property types in which the fund is investing. They should demonstrate a high level of adaptability and the ability to apply their expertise to maximize your benefits.
A reputable sponsor/manager should provide you with information about the underlying investment and where your money will be directed. They should help you understand the downside risks, explain various scenarios , and discuss the potential penalties for early withdrawal.
You should also do your due diligence and ensure that the fund is and remains certified. Otherwise, you may have to pay the capital gains taxes you are trying to defer, plus any penalties that may be assessed.
Invest in locations with high growth potential
One of the beautiful beaches of Puerto Rico
Invest in low-risk, high-return assets
Recommended Reading: Free Stocks To Invest In
How To Start Investing In Qualified Opportunity Funds
In order to make sure youre following the rules, considering all potential implications and filing the appropriate paperwork, consulting with tax or financial advisors well-versed in qualified opportunity funds can help smooth the investment process.
Whether an investor is eligible to use opportunity zones depends on the character of the gain and timing of that gain, Homan says.
She recommends that investors who are interested in qualified opportunity funds and have gains start out by talking with their accountant. Thats really your first step to become equipped and know this is the timing Im working with, this is the amount of capital I have, and then your next step is looking at your options in the marketplace.
Despite needing to jump through some hoops, opportunity zone investments are compelling.
For investors, there are a number of funds to evaluate, and you can also look at investing in individual deals. This is a really active marketplace and one of the most significant tax incentives in a generation. Its going to do a whole lot of good, Homan says.
What Is An Opportunity Fund
An opportunity fund is an investment vehicle designed to invest in real estate or business development in areas known as opportunity zones.
Opportunity zones are particular geographic areas that have been designated as economically distressed. As a result, these areas may be subject to different economic regulations than other regions in the country or state. Tax incentives for investments in opportunity zones include delayed and potentially reduced taxes on capital gains.
Also Check: Best Investments For 40 Year Olds
Investing In Opportunity Zone Properties
Opportunity funds must make substantial improvements to the properties in which they invest. The TCJA defines substantial improvements as investments in the property that are equal to the original value paid by the fund. These must be made within 30 months. For example, if a property is purchased for $700,000, then the opportunity fund has a 30-month window to make at least $700,000 worth of improvements.
Certain types of businesses cannot be included in opportunity funds, even if they reside within opportunity zones. They include:
- Golf courses
- Racetracks or other facilities used for gambling
- Liquor stores
Investors can defer their tax payments on prior investment gains if those gains are then invested in a qualified opportunity fund within 180 days after the sale. Taxes are then deferred to either the day when the opportunity fund investment is sold or exchanged, or Dec. 31, 2026whichever comes first.
Estate Planning With Qofs
If a QOF is gifted to a charity or an individual other than the taxpayer’s spouse, this gift would be considered an inclusion event and may trigger the inclusion of the deferred capital gains in the taxpayer’s taxable income in the year the gift is made. If a QOF is gifted to a grantor trust or distributed to a taxpayers beneficiaries upon death, it should not be considered an inclusion event. (For more information on grantor trusts, please see Trusts and Taxes: Exploring the Federal Income Tax Implications of Trust Strategies.
Further, if a QOF is gifted to a grantor trust or distributed upon death prior to December 31, 2026, there will be no step-up in cost basis in the QOF. Although there is no step-up in cost basis, the taxpayer’s holding period in the QOF will tack on or carry over to the beneficiary of the QOF. However, this may present an income tax issue for the beneficiary if the beneficiary does not hold sufficient liquid assets to cover the impending deferred capital gains tax liability associated with the QOF.
Example 5In April 2020, Tiffany’s cost basis in the QOF is considered to be zero even though she contributed $5 million. In 2021, Tiffany dies and leaves her interest in the QOF to Diana, her 25-year-old daughter.
If a QOF owner intends to distribute a QOF upon death, the owner may want to consider providing additional funds to the recipient to cover the potential income tax liability.
Also Check: Where Can I Get Investment Advice
Does My State Recognize Opportunity Zones
Helberg said that investors must ensure that their state recognizes the tax deferral of opportunity zones.
California is one example where the state does not conform with the federal initiative, Helberg said. It is important to consider the state income tax implications when evaluating the costs and benefits of investing in an opportunity zone.
Complete 8 Step Guide To Investing In Opportunity Zones
While it may be clear that Opportunity Zones present great benefits to those who invest, it hasnt always been made entirely clear how to go about making an investment.
The program, which was enacted as part of the December 2017 Tax Cuts and Jobs Act, offers three levels of tax benefits to participating investors and developers .
So, to clear the air on investing in Opportunity Zones, below is an 8-step guide describing exactly how to invest in Opportunity Zones across the nation, no matter the asset type youre looking for or market youre looking in.
Don’t Miss: Can I Invest In Sequoia Capital
The Tax Incentives Outlined
There are three potential tax incentives to investing in economically distressed communities:
A temporary deferral: An investor can defer capital gains until 2026 by putting and keeping realized gains in an OZ Fund.
A reduction in capital gains: the original amount of capital gains on which an investor has to pay deferred taxes is reduced by 10% if the OZ Fund investment is held for 5 years and another 5% if held for 7 years.
An exemption of capital gains on appreciation: any capital gains on investments made through the OZ Fund accrue tax-free as long as the investor holds them for at least 10 years.
A Potential Alternative To A Qof
For individuals looking for ways to potentially defer federal capital gains tax liability and may be considering a QOF, a 1031 exchange may be a potential alternative. The 1031 exchange predates a QOF and both are designed to reduce or eliminate capital gains tax liability. While the potential tax benefits are similar, there are also important differences between these 2 strategies, including the fact that an intermediary may be required to complete a 1031 exchange. A 1031 exchange allows a taxpayer to defer recognition of capital gains incurred upon the sale of an investment property by reinvesting the proceeds in a like-kind property of equal or greater value within a certain time frame.8 To defer recognition of capital gains with a 1031 exchange, an individual must identify a replacement property within 45 days of the sale date of the current property and complete the purchase of the replacement property within 180 days. Individuals should work with their legal, tax, and financial advisors to determine which, if any, of these strategies may be appropriate for them.
You May Like: Difference Between Broker Dealer And Investment Advisor
Qualified Opportunity Zones: Tax Planning For 2022
The Qualified Opportunity Zone incentive program was created in late 2017 as part of the Tax Cuts and Jobs Act . This program was built to incentivize taxpayers to invest in economically depressed regions, providing both temporary and permanent tax breaks to program participants.
Even though the QOZ incentive has been around for years, its worth revisiting. In these past three or four years, a couple of things have happened:
- Some of the programs benefits have expired.
- Players in the construction industry have had the time to flesh out their roles in the program, allowing for more taxpayer participation than when the program was first implemented.
Lets look at opportunity zones with a fresh set of eyes so that we understand what QOZ investment options look like today, and we see what role they can play in our clients short- andlong-term tax plans.