My favorite quote that I read about opportunity zones thus far is from a representative of Skybridge capital. “Opportunity Zones are like high school sex, everyone is talking about it, but no one is actually doing it.” But what are these zones full of opportunity and why is it difficult to invest in them? Let’s explore what an Opportunity Zone is, how to take advantage of its tax benefits, and the difficulties of participating in the new tax law.
Per the IRS website, Opportunity Zones are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities. They were passed in the December 2017 new tax law called the Investing In Opportunity Act. Essentially the tax law gives a very attractive capital gains tax break for those who invest in low income neighborhoods designated by the US Government. There are three things to explore. What are the tax breaks, where are the regions designated as opportunity zones located, and how to invest in them.
Opportunity Zone (OZ) tax breaks only apply to capital gains, which are profits on investments held for more than one year. Currently the top capital gains tax bracket is 20% plus another 3.8% for the Net Investment Income Tax. If you sell an investment and invest the capital gains within 180 days of the asset sale, investors can defer paying capital gains taxes on that gain or potential reduce their capital gains tax liability to zero. Per the IRS website FAQ about Opportunity Zones, they state the below in reference to the tax breaks offered.
Opportunity zones are designed to spur economic development by providing tax benefits to investors. 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.”
Holding onto the OZ investment for 10 years is what really makes it sing. In short, after a 10-year holding period, there would be zero federal capital gains tax on profits from the sale of an investment in an Opportunity Fund. It even allows for the taxpayer to elect to exclude from gross income the post-acquisition gain on investments in the QOF held for at least 10 years.
Where are Opportunity Zones located?
The U.S. government has outlined certain “opportunity zones,” or low-income areas. Again referencing the IRS website;
The list of designated Qualified Opportunity Zones can be found in IRS Notices 2018-48 (PDF) and 2019-42 (PDF). Further, a visual map of the census tracts designated as Qualified Opportunity Zones may also be found at Opportunity Zones Resources.”
How to invest in opportunity Zones
Now here is the tricky part, which I have yet to find a suitable solution. In order to qualify for the tax break you have to invest in a QOF, Qualified Opportunity-Zone Fund. I believe there are two ways to achieve this. The easier approach is to invest directly into a fund. You can find some with some web searches or perhaps contact an advisor at Goldman Sachs or other large brokerage firm’s private wealth divisions. My reservation with using a QOF is that you are subject to their fees, for a long time. Let’s say you get comfortable with their fees in the short term, what happens if they are increased in years 7-10? Will you sell the investment? Not likely since you are so close to the 100% tax free status.
The second way is the DIY method, which can be achieved by creating a LLC and organizing as a Qualified Opportunity Fund, which is done by filling out some forms.
To become a Qualified Opportunity Fund, an eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return. For additional information, see Form 8996 and its instructions. The return with Form 8996 must be filed timely, taking extensions into account.”
In the LLC, you can invest or operate a businesses that conducts most or all of it’s operations within a qualified Opportunity Zone. Another option is to buy a property that you plan on rehabilitating or expanding in an Opportunity Zone for investment. In order for the property to qualify as an investment, you need to invest 100% or more of the property basis over the next 30 months. Let’s use an example of buying a property for 100,000. The land is worth 40,000 and the structure is worth 60,000. In order to be a qualified opportunity zone investment you must invest 60,000 or more into the property. You can find more details here, per the IRS.
On the surface, opportunity zones seem like a too good to be true investment. But, as you get into the details, it’s not that easy. Sure, investing in a fund is easy but the fees can really add up over a 10-year time period. Plus, fund options are limited with likely high net worth individuals only having access to the best ones. The do it yourself method involves a timely process of setting up an LLC and a fix and long term hold strategy of the purchased property. But, for those with a large capital gain that want to diversify with some incredible tax benefits, the work of figuring out how to take advantage of the new tax law will be well rewarded.