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The Tax Benefits of Investing in Qualified Opportunity Zones

June 23, 2022.

The Tax Benefits of Investing in Qualified Opportunity Zones

To stimulate economic growth and development in lower-income areas, the federal government launched the “Opportunity Zone” program in 2017 as part of the Tax Cuts and Jobs Act.  The program has proven to be an excellent alternative for deferring, reducing or even excluding capital gains tax altogether.

What is a qualified opportunity zone?

A qualified opportunity zone (QOZ) is an economically distressed community where new investments may be eligible for preferred tax treatment under certain conditions. In total, there are more than 8,700 census tracts designated as QOZs. These communities all had a poverty rate of at least 20% as of the 2010 census (the most current data at the time of establishing the zones).

Qualified Opportunity Funds

To invest in a QOZ, an investor must use a qualified opportunity fund (QOF). A QOF is an investment vehicle organized as either a partnership or corporation that holds at least 90% of its assets in QOZ property. A limited liability company (LLC) may be a QOF if it chooses to be treated as a partnership or corporation for federal income tax purposes and is organized specifically to invest in a QOZ property.

QOF Tax Benefits

QOFs offer a unique opportunity for investors with realized capital gains.  When realized gains are reinvested into QOFs (within a certain period of time, generally 180 days), an investor can potentially benefit from the following “triple-layer” tax incentives:

Deferral: Those who roll over their capital gains into a QOF can defer capital gain recognition from the original investment until December 31, 2026.

Reduction: The amount of capital gain recognized from the original investment is reduced by 10% after achieving a five-year holding period if that five-year holding period is achieved by December 31, 2026.

Exclusion: Long-term investors are eligible to pay no capital gains tax on the appreciation of their QOF investment upon disposition of that investment, regardless of the size of that gain, if the assets held in that QOF are held for at least 10 years. This last tax incentive could be very powerful depending on the ultimate performance of the QOF investment.

Furthermore, OZ investments qualify during a 1031 exchange, meaning investors trading from one asset can trade into an asset located in a QOZ to defer paying capital gains.

Risks Associated With Opportunity Zone Investing

  • The tax benefits associated with qualified opportunity investments are not guaranteed and could be reversed or reduced in future legislation.
  • Most QOF’s are organized as pass-through investments and have unique tax characteristics that could impact an investor’s tax situation.
  • Since QOZs are newly formed entities with no operating history, there’s no assurance of investment return, property appreciation, profits or resale opportunity. Investors must accept the reality that the investment may lose value over time.
  • OZ investments are generally located in secondary markets, limiting liquidity options.
  • Underwriting the portfolio holdings in OZ funds can be difficult. As such, market prices for most of a fund’s holdings will not be readily available.
  • OZ funds are leveraged, which increases the investment’s exposure to factors such as rising interest rates, downturns in the economy and deterioration in the condition of the assets underlying the investments. Assets are also at risk of foreclosure.

Investing in an OZ is a Long-Term Investment

Investors pursuing OZ investments should consider that investing in an opportunity zone is a long-term strategy.  The investments typically have long lock-up periods and are therefore relatively illiquid.  In most cases, return of capital and realization of gains, if any, do not generally occur until selling or refinancing the asset. Furthermore, if a property loses a tenant or sustains damage, there is a potential for disruption in cash flow distributions.

Conclusion

OZ investments were designed to provide significant tax breaks in order to incentivize investors to put money into underperforming areas around the country.  While these tax incentives are a big potential benefit, OZ investing has unique risks that should be scrutinized in detail before making any investment decisions can be made.  It’s important to consult with a professional that is experienced in opportunity zone investing before making any decisions.

 

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References

Gersten, Ehud.  What Investors Need to Know About Investing in Opportunity Zones.  What Investors Need To Know About Investing In Opportunity Zones (forbes.com).  June, 23, 2022.

 

The information in this article is general in nature and for informational purposes only.  None of this information is intended to be personalized (and tailored to an individual’s unique circumstances) and should never be construed as specific tax, legal or financial recommendations.  Before making any financial decisions, you are strongly encouraged to first consult with a qualified financial professional.

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