Opportunity Zone Funds

Background

There are more than 8,700 census tracts in U.S. urban, suburban, and rural areas that America’s governors and mayors have designated as QOZs. To qualify, these properties must be in an “opportunity zone” as designated by the state in which it resides and certified by the U.S. Department of the Treasury. The designation was created under the 2017 Tax Cuts and Jobs Act to stimulate growth and improve struggling economic areas of the country. 

The National Council of State Housing Agencies has a regularly updated directory of multi-project QOZ funds which, as of January 2024, lists over 240 funds representing nearly $50B in anticipated investment that have a national, regional, or state focus and cover industries varying from commercial real estate to affordable housing and more.

In many cases, opportunity zone properties are new construction. However, there are certain circumstances under which a pre-existing property within the zone can qualify. A fund that purchases a pre-existing property must make “substantial improvements” to the property, defined as equal to the fund’s initial investment into the property over a 30-month period.

Therefore, if a fund were to acquire a property for $5 million, they would have to invest an additional $5 million in improvements over the next two and a half years. Some types of properties, such as golf courses and gambling establishments, are ineligible for opportunity zone investments.

Tax Advantages

According to the IRS, investment into an QOZ fund can provide investors with significant tax advantages, and even savings, depending on how long the investment is held. Current law allows QOZ investors to defer paying taxes on their investments until 2026. If a QOZ investment is held for 10 years, any appreciation on the investment essentially becomes tax-free.

Certain expired provisions of the law allowed QOZ investors to enjoy a 10% reduction in initially deferred capital gains. For instance, if the investment was held for five years, 10% of the original gains invested became tax-free due to a step-up in tax basis. Any depreciation in the fund also decreases the tax-basis of the original investment. And, if the investment was held for seven years, an additional 5% of the gains became tax-free.

However, the deadlines for investments to achieve both benefits passed on December 31, 2021. Even though the deadlines have passed, QOZ funds still offer clients the opportunity to defer tax on 2021 capital gains for up to five years into the future.

Because of the 2026 deadline for declaring deferred capital gains, investors would have had to make an investment on or before December 31, 2021 in order to claim the 15% and 10% step up in tax basis. While QOZ investors can no longer receive a step-up in basis, the good news is that the majority of the potential tax benefit comes from the ability to exit the investment tax-free if held for 10 years.

IRS Guidance

The basic rules governing QOZ funds were finalized in late 2019, with very little additional guidance released since, save for a few updates related to the COVID-19 pandemic.

Eligible Capital Gains

When investing in opportunity zones, investors rollover capital gains from one investment to another. But there are some restrictions on where those gains can come from. Only capital gains that are taxable in the United States may be invested. Non-residents and foreign corporations may still make investments if their capital gains are connected to a U.S. trade or business.

Delayed Exchanges

As with 1031 Exchanges, QOZ Funds allow for up to 180 days between the sale of an investment and the reinvestment into the new fund. For certain types of investors, there are rules governing when that delay period starts. Investors that have a stake in a partnership, S corporation, are beneficiaries of an estate, or non-grantor trusts may start their investment window from the date on which that entity must hand in their tax return (excluding extensions).

If investing gains from a Real Estate Investment Trust or a Regulated Investment Company, investors may start their investment window from the end of the tax year, or the investor may elect to start their window at the date when they receive their capital gains dividends. Proceeds from installment payments may be invested even if the initial payment was before 2018.