You probably heard something about the tax benefits that can be reaped from investing in the new “qualified opportunity zones.” But you probably haven’t heard all you need to know before making a decision.
The tax benefits of investing in qualified opportunity zones (QOZs) were created by the Tax Cuts and Jobs Act, enacted at the end of 2017. The goal is to encourage private investments in economically disadvantaged areas throughout the country.
Each state designates areas as QOZs, and they’ve been doing that since the law was enacted. Financial services firms and other businesses followed by creating vehicles for people to invest in QOZs, known as QOZFs or QOZ funds. The funds usually are partnerships or corporations.
Let’s look first at the tax benefits.
The big benefit is you can defer taxes on long-term capital gains by investing the gains in a QOZ fund. The investment has to be made within 180 days of the event that triggered the gain. So, it’s best to be aware of the advantages of a QOZ fund investment and look for a fund before recognizing a large capital gain.
Once the investment is made, the gain can be deferred until the earlier of December 31, 2026, or the date on which the QOZ fund is sold or exchanged.
When the QOZ fund is held for at least five years, the deferred gain is reduced by 10%. In other words, there will be no capital gains on 10% of the deferred gain. Hold the QOZ fund for at least seven years and the deferred gain is reduced by 15%. That’s a total of 15%, not another 15% on top of the 10%. The biggest benefit is available when the investment is held for at least 10 years.
Then, in addition to the 15% reduction in the deferred gain, you get to increase the basis in the QOZ fund investment to its fair market value on the date it is sold. That means any gain from selling the QOZ fund investment is tax free. In materials for many QOZ funds, you’ll see projections of substantial gains over time.
The idea is that new investments will come into the economically distressed area and turn it around, increasing property values. In addition to the tax benefits and potential investment gains, many people are attracted by the idea of making investments in areas close to home that need help.
QOZ funds are especially attractive to people who are looking to recognize substantial capital gains, especially through the sale of a small business or commercial real estate.
Someone with substantial capital gains from securities investments also might want to consider a QOZ fund to defer taxes on the gains. Let’s look at some details that won’t be emphasized in many of the presentations on QOZ funds.
There are a lot of fine points of tax law that must be followed, and some questions still haven’t been answered in the IRS guidance issued so far. You have to depend on the fund sponsor to interpret the rules and follow them correctly so that you receive the tax benefits.
The QOZ funds are organized primarily by financial services and real estate syndication firms. They harken back to the old days of tax shelter partnerships. Two key risks of those investments were high fees and illiquidity. Those risks apply to QOZ funds today.
Be sure to find in the offering materials how much of the investment will go to fees and administrative expenses and how much actually will be invested. The lower the investment amount, the lower your potential investment return. A QOZ fund is a long-term investment, lasting up to 10 years and possibly longer, that you’re unlikely to be able to sell at a reasonable price before the end of the planned investment period. If you might need the cash, don’t make the investment.
Of course, there is investment risk. The economically disadvantaged area might continue to struggle, in which case the fund won’t be able to recoup its investment, much less make a profit. Key point: A QOZ investment defers taxes on your original capital gain for a stated period as described earlier.
After the deferral period, you owe the taxes on the gains, even if the QOZ investment doesn’t do well or the QOZ fund hasn’t been sold or liquidated. You’ll need cash to pay the deferred taxes. Some funds plan to invest primarily in one QOZ. Other funds plan to diversify across a region or the nation. Decide which approach you prefer.
A QOZ fund doesn’t have to be 100% in QOZs to qualify for the tax benefits. Some funds plan to diversify with some non-QOZ investments to reduce risk, but that also might reduce returns. You don’t want to be stuck with a fund sponsor that has a short-term outlook or is in a rush to invest.
I suspect a number of QOZ funds will overpay for properties. They’ll feel the pressure to invest in a QOZ before other people do or will accept a liberal assessment of a property’s value. You also have to review your state tax law. Some states conform their tax codes to the federal code, so you’ll receive all the QOZ benefits on your state tax return.
But not all states recognize QOZ tax benefits. Also, it’s possible the QOZ fund will sell investments before holding them long enough to qualify for the tax benefits or will otherwise run afoul of the QOZ law. There’s a lot to consider before investing in a QOZ fund. Don’t focus on the potential tax benefits to the exclusion of the fees, experience of the fund sponsor and real investment potential of the project.