What are Qualified Opportunity Zones and How Do They Benefit Real Estate Investors?
There are countless low-income communities throughout the United States, many in dire need of economic growth and job opportunities for local residents. To help combat this problem, the Tax Cuts and Jobs Act was passed in 2017. This was put in place to establish Qualified Opportunity Zones (QOZs), a new tax incentive for individuals to invest funds into low-income areas.
What are Qualified Opportunity Zones?
Qualified Opportunity Zones are distressed areas throughout the U.S. designated by the governors of each state as low-income communities in need of development. Investors who put funds into these areas receive several tax benefits, including the option to defer capital gains tax, receive a step-up in basis in prior gains invested, and more. Put simply, the purpose of the Opportunity Zone program is to enhance communities in need while giving investors several tax benefits to motivate them to invest.
How Can Individuals Invest in Qualified Opportunity Zones?
Individuals who earn capital gains from selling stocks, businesses, real estate, cryptocurrency, or other investments before January 1, 2027, can put the gains into a Qualified Opportunity Fund, which is a corporation or partnership that invests 90% or more of assets into a Qualified Opportunity Zone. A Qualified Opportunity Fund can invest in businesses, equipment, or property in an Opportunity Zone – it isn’t solely restricted to real estate. If the fund invests in real estate, significant improvements must be made to the property within a set period of time, such as redevelopment, construction, or capital improvements.
How Do Qualified Opportunity Zones Benefit Investors?
After selling stocks, real estate, a business, or any other investment, individuals have 180 days to select a Qualified Opportunity Fund investment and file a Form 8949 and a Form 8997. Doing so provides the following tax benefits:
Tax Deferral When an investor sells real estate, stocks, or any other investment for a profit, taxes are owed to the IRS on that gain, which is referred to as ‘capital gains tax.’ However, individuals who choose to roll those funds into an Opportunity Zone can defer taxes until December 31, 2026, or until they decide to sell the property in the Qualified Opportunity Zone – whichever comes first.
Tax Reduction Those who choose to invest in a Qualified Opportunity Zone before the end of 2021 and hold the asset for five years (2021 - 2026) will reduce their capital gains tax by 10 percent. Investments held for ten or more years will not have to pay any capital gains tax on the returns they earn from the Opportunity Zone investment.
How Do Qualified Opportunity Zones Benefit 1031 Exchange Investors?
Investors interested in selling a current piece of income-producing property or portfolio of properties can defer taxes by participating in a 1031 exchange, which involves rolling the proceeds from the sale of a property/properties into a second real estate investment. However, some investors may not want to do a 1031 exchange and prefer to put their money into an Opportunity Zone investment or fund instead. For investors who want to defer taxes and keep their money in real estate without purchasing and managing a new income-producing property on their own, a Qualified Opportunity Fund can be a great alternative.
While there are several benefits to participating in a 1031 exchange, a Qualified Opportunity Zone investment has some advantages that a 1031 exchange may not offer, including:
1. Option to Only Invest Capital Gains When investing in a 1031 exchange, all proceeds from the sale of the property must be rolled into the second investment. With a Qualified Opportunity Fund, only the capital gains must be reinvested to receive the tax benefits – not all sale proceeds. Investors will often continue investing in 1031 exchanges over the course of their life because there’s a major step-up in basis after their death and their children inherit tax-free real estate (i.e., Swap ‘til you drop). However, investing in a Qualified Opportunity Zone gives investors the option to pull out their basis from the last investment and only invest the capital gains into a Qualified Opportunity Fund. This can help investors reset their bases on new investments and eliminates any timelines for reinvestment.
2. Diversification There are several ways to invest in Opportunity Zones beyond just real estate. There are Qualified Opportunity Zone Funds designated to benefit local businesses, infrastructure development, and more. Opportunity Zone investments also offer a hedge against changes to the 1031 tax code. In the current political environment, it is entirely plausible that the “Swap til you drop” provision of the 1031 tax code could be eliminated. Using the benefits of Opportunity Zones can give investors and their families peace of mind knowing their investments are diversified among several tax shelters.
3. Streamlined Investing Process Investing in a 1031 exchange involves hiring a Qualified Intermediary and identifying a replacement property (or properties) in 45 days or less. The investor must then close on the property within 180 days or they run the risk of paying capital gains tax. While there are numerous benefits to 1031s, having only 45 days to identify a property can be stressful for many investors.
Alternatively, investors interested in a Qualified Opportunity Fund have 180 days to identify the fund and file a Form 8949 and a Form 8997. Investing in Qualified Opportunity Zones can often be a more streamlined process that doesn’t involve as many involved parties – such as the Qualified Intermediary, a Real Estate Broker to show available properties for sale, etc. – and gives investors a bit more time to review various investment options.
4. Less Restrictive When investing in a 1031 exchange, the property must be “like-kind,” meaning it must be an income-producing property used for productive use in a trade or business and must be exchanged into a second income-producing property (vs. a primary residence). Investing in a Qualified Opportunity Zone is less restrictive, allowing investors to use the capital gains for development projects or new businesses.
Overall, 1031’s and Opportunity Zone’s have numerous benefits for investors and both options should be weighed carefully to determine the best vehicle for future investment.