The Tax Cuts and Jobs Act of 2017 made some major changes to the Internal Revenue Code. For real estate investors, one of the most potentially significant updates involved the creation of Qualified Opportunity Zones. Technically speaking, these Opportunity Zones exist to encourage investment in economically distressed areas. But, when used properly, they also provide real estate investors an incredible opportunity for preferential tax treatment.
As such, we’ll use this article to provide an Opportunity Zone real estate investing overview. Specifically, we’ll cover the following topics:
- Qualified Opportunity Zone Overview and Tax Benefits
- Qualified Opportunity Funds
- QOF Real Estate Considerations
- Final Thoughts
Qualified Opportunity Zone Overview and Tax Benefits
According to the IRS, a Qualified Opportunity Zone, or QOZ is: an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. In theory, this preferential tax treatment will spur investment in these distressed communities.
Currently, individual localities qualify as QOZs if: they have been nominated for that designation by a state, the District of Columbia, or a U.S. territory and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service (IRS). Currently, all 50 states and Washington, DC have designated QOZs within their boundaries.
From a tax perspective, investing in QOZs provides the potential for capital gains 1) tax deferral, 2) tax reduction, and 3) tax avoidance. In general terms, investors take capital gains from one sale and roll the amount of those gains into a QOZ investment. For example, say you have $150,000 in capital gains from a stock sale. If you invest $150,000 in a QOZ within IRS guidelines, you can elect to defer the capital gains tax on that $150,000 (NOTE: Investors make this deferral election via IRS Form 8949, Sales and Other Dispositions of Capital Assets. And, you can elect to defer part or all of the tax on the original capital gain).
And, how long you defer paying taxes on those gains depends on how long your money remains invested in the QOZ. More precisely, investors can defer tax on the invested gain amounts until the date they sell or exchange the [QOZ] investment, or Dec. 31, 2026, whichever is earlier. In other words, you will recognize the original gain no later than January 1st, 2027.
The duration you hold your funds in the QOZ investment also affects a potential reduction in total taxes. Technically speaking, when you make your initial QOZ investment, you have a $0 basis, meaning an immediate sale would trigger 100% of your original capital gains tax liability. But,
- If the investor holds the [QOZ] investment for at least five years, the basis of the [QOZ] investment increases by 10% of the deferred gain.
- If the investor holds the [QOZ] investment for at least seven years, the basis of the [QOZ] investment increases to 15% of the deferred gain.
This means that, as originally conceived, QOZs let investors A) defer capital gains taxes, and B) reduce that tax liability by up to 15%. However, as the Opportunity Zone tax deferral system ends December 31st, 2026, new investors can no longer qualify for the seven-year, 15% increase in basis. But, they still can qualify for A) deferral, and B) the five-year, 10% increase in basis.
As advantageous as tax deferral and reduction prove, the true value in QOZ investments comes with tax avoidance:
- If the investor holds the investment in the [QOZ] for at least 10 years, the investor is eligible to elect to adjust the basis of the [QOZ] investment to its fair market value on the date that the [QOZ] investment is sold or exchanged.
We’ll use an example to illustrate just how valuable this can be. Assume you invest $100,000 into a QOZ. In your 2027 filing, you recognize the taxes on those initial capital gains, paying either the full or reduced tax amount. But, say that you decide to hold that $100,000 investment for 10 years. At the 10-year mark, your initial $100,000 investment is now worth $500,000. When you sell your investment, you can elect to adjust its basis to fair market value, that is, sale price. Put simply, you can sell your investment for $500,000 with no capital gains tax!
Qualified Opportunity Funds
If you see the incredible potential in Opportunity Zones, you’re likely asking: how do I invest? The IRS has declared that all QOZ investments must be made through a designated Qualified Opportunity Fund, or QOF.
The IRS defines a QOF as: an investment vehicle that files either a partnership or corporate federal income tax return and is organized for the purpose of investing in QOZ property. And, the IRS has also accounted for the prevalence of LLCs – a state-level entity – in providing QOF guidance: An LLC that chooses to be treated either as a partnership or corporation for federal income tax purposes can organize as a QOF.
Creating these funds proves fairly straightforward: to become a QOF, an eligible corporation or partnership self-certifies by annually filing Form 8996 with its federal income tax return. The return with the Form 8996 must be filed timely, taking extensions into account. Alternatively, investors can find existing QOFs rather than creating their own. This provides the ability to reap the tax benefits without the administrative burden of forming and managing your own QOF.
QOF Real Estate Considerations
The QOZ program offers particularly incredible benefits to real estate investors. In addition to the aforementioned tax benefits, real estate investors also receive another major advantage. Normally, when you sell an income-producing property, you must pay a depreciation recapture tax. At a flat 25% on allowed MACRS depreciation for the holding period, this tax can significantly cut into a deal’s profits. When you sell QOF real estate following the requisite 10-year hold period, depreciation recapture will no longer be taxed.
But, real estate investors must also meet specific requirements to qualify for QOF treatment. As stated, the core purpose of the Opportunity Zone program is improving economically distressed areas. Accordingly, the federal government and, by extension, the IRS want to make sure real estate QOFs actually improve their investments. To this end, QOFs must substantially improve any real estate they purchase to qualify. According to the IRS: Property is substantially improved if, during any 30-month period beginning after the property is acquired, additions to the basis of the property exceed an amount equal to the adjusted basis at the start of the 30-month period.
In layman’s terms, you have to invest double your adjusted basis into improving the QOF real estate. Simply buying and managing a stabilized apartment building in an Opportunity Zone won’t qualify for preferential treatment, as that doesn’t entail any actual improvement.
To be clear, we only scratched the surface of Opportunity Zone investing in this article. Our goal was not to make you an expert. Rather, we hope the above exposes you to the incredible tax advantages offered by investing in a QOF, particularly one focused on real estate.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat. Drop us a note, and we’ll set up a meeting to talk about available investment opportunities – with a particular focus on QOFs!