Investing in Opportunity Zones: What Are They and How Do They Work?Submitted by Durbin Bennett on July 25th, 2019
If you have been curious about Opportunity Zones, you aren’t the only one. We’ve been researching this topic too and felt it important that we share some helpful knowledge to our clients as well as any investors considering this as a potential investment.
What are Opportunity Zones?
In 2017 a new tax legislation was signed into law called the Tax Cuts and Jobs Act. The primary purpose of this new legislation was to establish tax incentives for investors to invest in underdeveloped markets, which were called Opportunity Zones. An Opportunity Zone is characterized as an area that:
● Is economically distressed and struggling to attract capital
● Has never recovered from the recession of 2009
● Has low median household income
● Has low-housing density urban neighborhoods
● Can contain student housing and industrial parks
As of December 2018, state governors and the U.S. Treasury have identified and designated approximately 8,700 Qualified Opportunity Zones (QOZ).
An example of a QOZ in Austin, Texas is the Riverside area expanding out to the airport, which houses numerous industrial warehouses. This area meets the criteria identified by the US government as an underserved community.
How does the Opportunity Zone Program work?
The Opportunity Zone Program allows an investor to sell an asset (it does not have to be a real estate asset), and defer the capital gains from said asset into a real estate asset or business that is located within one of the 8,700 QOZs in the U.S. For example, if you sell part of your equity portfolio and create $1 million dollars in capital gains, then you can put that $1 million into a QOZ project.
When an investor and his or her partners pool their capital gains together to invest in a QOZ project, it is called the Opportunity Zone Fund (OZF). This makes them eligible to defer taxes and to receive future capital gains tax incentives, depending upon how long the future investment is held. There are strict rules of engagement and if not followed to the letter, it could result in a tax penalty.
A typical OZF timeline extends from six months to 10 years (2019 – 2028):
● Investor has six months to roll capital gains into OZF
● If the asset is sold within five years, it and the capital gains are fully taxed with interest
● If the asset is held for five years, 90 percent of the rollover capital gains are taxable
● If the asset is held for a total of 10 years, capital gains are forgiven on the new investment
OZFs must adhere to guidelines set forth by the Opportunity Zone Program. OZFs must invest in properties that operate within a QOZ (one of the 8,700 identified in the U.S.) and include real estate, partnership interests and stock ownership in a business. Additionally, OZFs must develop or redevelop properties within 31 months and are required to invest in improvements valued at the equal amount of the purchase price. Should the OZF not meet the 31 month completion requirement, it will be penalized by the IRS.
Other facts to keep in mind regarding OZFs:
● Partners may charge a property management fee (fees average around 1.75 percent but can vary)
● The OZF must pass the 90 percent test, which states that 90 percent of the assets must be in a QOZ investment
● The OZF should be active for more than 10 years in order to take advantage of all tax incentives
● Investors and partners must maintain the property to meet certain requirements in order to be eligible for the Opportunity Zone Program
Who and why should you invest in an OZF?
Investors with a substantial amount of realized capital gains are the best prospective targets for these funds. Tax benefits are the biggest incentive for investing, however many of the QOZ projects are considered social impact investment opportunities that have the potential to improve development in many low-income neighborhoods (i.e. job opportunities, shopping and social engagement resources, and better quality of life). From this perspective, investing in an OZF is a win-win for investors, but there are risks as well, which we’ll address in our next blog post.
There is certainly no shortage of opportunities to invest in QOZs. However, as with any investment, you’ll want to work with your advisor to determine the appropriateness of this asset and how it affects your overall goals and risk tolerance.
If you’re interested in setting up an appointment with an advisor and learning more about QOZs, send us an email at firstname.lastname@example.org.