Qualified Opportunity Zones
Established by the IRS to incentivize investment in low-income areas, the Opportunity Zone program is relatively new, and many investors are still unfamiliar with the benefits it provides. As of April 2018, the IRS offers tax benefits on long-term real estate investments purchased within Qualified Opportunity Zones. So what does this mean for long-term investors? Today we dive into the basics of Opportunity Zones and their three major draws.
What’s an Opportunity Zone?
Qualified Opportunity Zones or QOZ are economically distressed areas in which the government has designated certain tax incentives for investors. Typically, this means a capital gains investment is tax-deferred and the deferred gain is eligible for a partial exemption after five years or more. As described on IRS.gov website:
An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.”https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
The preferential tax treatment described above only applies to purchases made with capital gains, and only for investment properties. In other words, homebuyers who plan on living in the house are ineligible for preferential tax treatment even if it is within an Opportunity Zone.
In order to establish an investment in an Opportunity Zone, investors must establish a Qualified Opportunity Fund (QOF) as a vehicle for investment property funds.
EIG.org provides a great resource for understanding Opportunity Zones.
Why invest in an Opportunity Zone?
1. Deferred tax
Okay, this one is obvious. After all, deferred tax is the primary incentive to investors, and is effective immediately upon investing.
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.”https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
This means that the investor has seven full years to defer on the reinvested gains before tax is owed. An investor may be able to defer taxes further with a 1031 exchange before the 2026 deadline.
2. Tax exemptions
In addition to deferring taxes, Opportunity Zones incentivize long-term investments by adjusting the basis on which tax is owed:
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.”https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
This is where things get good. The tax-deferred gains you invested are eligible for 15% exclusion after seven years, meaning you only owe tax on 85%. Additionally, if the investment is held for ten years, it is eligible for a step-up in basis to the fair market value. If the property was sold shortly after the ten-year mark, the investor would be paying no capital gains tax on appreciation. This is a huge incentive for someone already interested in long-term investment.
3. Economically growing areas
Opportunity Zones were designed to help boost economically distressed areas by incentivizing long-term investors with tax benefits. The first zones were designated on April 9, 2018, so we must wait to see if they will offer the long-term economic development expected.
However, what is expected through the program is that the influx of new investments will drive an increase in property value throughout the zone. Investors realize the greatest gain if they establish funds early and stay invested long-term while the property values continue to increase. It is almost a self-fulfilling prediction, but one that benefits the early investors most.
Now that you know more about Opportunity Zones and the advantages they can provide, you are well on your way to making an informed and financially successful investment. Having a knowledgeable agent to assist you will make your process smooth and your returns as high as possible.
This post is for informational purposes only. Contact a tax professional prior to making investment decisions.