Per the IRS.gov, “ Qualified Opportunity Zones were created by the 2017 Tax Cuts and Jobs Act. These zones are designed to spur economic development and job creation in distressed communities throughout the country and U.S. possessions by providing tax benefits to investors who invest eligible capital into these communities. Taxpayers may defer tax on eligible capital gains by making an appropriate investment in a Qualified Opportunity Fund and meeting other requirements.”
Since the inception of opportunity zones in 2017, the government has designed such zones in all 50 states, the District of Columbia and 5 U.S. Territories. In order to qualify as an Opportunity Zone the tract must be designated as a low-income community by meeting one of the following criteria. It must have a poverty rate of at least 20%, have a median family income that does not exceed 80% of the area median income, the tract must be contiguous with a designated low-income community and the median family income does not exceed 125% of the median family income in the contiguous designated low-income area.
So, how do Opportunity Zones help encourage economic development? According to the IRS, there are two ways in which they help to jump start the economy.
First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain. If held for more than 7 years, the 10% becomes 15%.
Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.
Now that we know what they are and where they came from, let’s talk about the incentives from an investors perspective. There are three federal tax incentives you can take advantage of as an investor to help encourage economic stimulation in these depressed areas.
Gains reinvested directly in an opportunity zone, or through an investment vehicle known as a qualified opportunity fund, are deferred until the earlier of either the sale of the investment or Dec. 31, 2026.
The basis of any investment in a qualified opportunity fund held for at least five years is increased by an amount equal to 10 percent of the amount of gain deferred under the opportunity zone program. If the investment is held for at least seven years, there is an additional 5 percent basis increase.
If a qualifying investment is held for at least 10 years, any built-in appreciation during the life of the qualifying investment is excluded from income.
The goal of opportunity zones is to produce a healthy return for the investors who are taking the risk with their capital to invest in areas that otherwise would not be considered. The benefits of this type of investment is fairly straightforward, but in a situation like this you have to consider that the risks may be just as great.
One thing to consider is that Opportunity Zones have only been around a short time and the government and IRS are still working out the kinks which means adding new rules and regulations as new issues come to light. This could put the investors at risk for unexpected tax liabilities as rules change and laws are updated. Security, compliance and transparency are huge components to successful transactions and it’s a good idea to go into this process with an independent, third party administrator to help you achieve these.
Security
The use of an independent third party to control and track the record keeping is something you will want to strongly consider. Investors will be more apt to move forward if they can trust that the data is security and being properly kept in order to provide accurate tax reporting.
Compliance
This is something you will want to pay very close attention to and track changes to prevent any unexpected tax bills as much as possible. As stated earlier, this is a newer program so you should expect the rules and regulations to change. The more you are on top of this the more prepared you will be.
Transparency
It is crucial that your administrator be transparent from day one. The complexity of this program and depending on the number of steak holders you have, this may be more difficult, but vital to keep everything running smooth and everyone happy.
Overall, Opportunity Zones can be a great investment. They can help your community and make you a great return on your investment. The key thing to remember is to do it right and keep a paper trail to help you navigate whatever changes may arise as this program continues to develop.
Sources:
irs.gov
ccim.com, article: Learning from Experience, Investing in Distressed Communities Brings Tax Benefit with New Opportunity Zone Program
marcusmillichap.com