Opportunity Zone Funds are a popular alternative investment vehicle for many investors. Given its overall zeal for the program, it is surprising to see how frequently investors and advisors misunderstand critical aspects of them.
Below, we outline five common myths even the most seasoned investors and advisors sometimes infer about Opportunity Zones.
Myth #1: An investor can only re-invest capital gains from real property sales into Opportunity Zone Funds
The Tax Cuts and Jobs Act of 2017 (TCJA) both created the Opportunity Zone program and at the same time limited 1031 exchanges.
The 1031 exchange has been around for decades, and many investors have used it to defer taxes in the past. The TCJA legislation limited 1031 exchanges to only be allowed when selling and acquiring real property. As a result, some advisors and investors incorrectly assume investments into Opportunity Zones using capital gains can only come from real property transactions.
Learn more about the differences between Opportunity Zone Funds and 1031 Exchanges by clicking here.
The TCJA allows investors to defer capital gains from any source when contributing to a Qualified Opportunity Zone.
This includes stock, cryptocurrency, business sales, and tangible personal assets too. Also, the capital gains can be short or long-term gains. Given the growth in many of these areas over the last couple of years, re-investing capital gains from other sources into Opportunity Zones has become a popular alternative investment for many investors.
Myth #2: The full gross proceeds from a sale needs to be contributed into an Opportunity Zone Fund to obtain a tax deferral
Many advisors and investors mistake the rules for 1031 exchanges with the Opportunity Zone Fund requirements.
In a 1031 exchange, an investor must invest the full gross proceeds from a sale of real estate to obtain a tax deferral. In comparison, with an Opportunity Zone Fund investment, an investor only needs to invest the capital gains portion to qualify for tax deferral.
For example, if a person sells a rental property for $1 million that results in a $300,000 capital gain, only the $300,000 capital gain needs to be invested into an Opportunity Zone Fund to qualify for the tax deferral. This allows investors to take out proceeds from the sale while still deferring tax.
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Myth #3: If an investor contributes capital gains into an Opportunity Zone Fund, the investor will never have to pay taxes on the capital gains contributed into the fund
An investor who contributes capital gains before December 31, 2021, will need to pay taxes on 90% of the capital gain on or before April 15, 2027, for the tax year ending December 31, 2026.
For example, if an investor sells a rental property for $1 million, but has a tax basis of $700,000, the investor will be subject to federal tax on $270,000 ($300,000 * 90%) of capital gains on their 2026 tax return. If the investor were to contribute into a Qualified Opportunity Zone after December 31, 2021, but before December 31, 2026, the investor would be required to pay capital gains tax on all $300,000 contributed into the fund on their 2026 tax return.
Once an investor pays the capital gains tax on their 2026 tax return and holds an investment for at least 10 years from their original investment date, the subsequent sale of the Opportunity Zone Fund investment will be tax-free.
For example, if an investor invests $300,000 on December 31, 2021, and sells the investment in January 2032 for $1 million, the $700,000 gain will not be subject to any federal taxes. The Opportunity Zone rules allow for a step-up in basis to the fair market value at the time of the sale as long as the original investment is held for 10 years.
Want to learn more about the power of using capital gains to defer tax? Click here to learn more.
Myth #4: An investor only has 180 days from the date of sale to invest in an Opportunity Zone Fund
If an investor has a capital gain from the sale of a direct, personally-owned asset, such as stock or a rental property, the investor will have 180 days from the date the asset is sold to re-invest the gain into an Opportunity Zone Fund.
However, there are other scenarios where the 180 days are not from the date of sale.
For Section 1231 gains, the same 180-day investment window applies, but the window begins on the last day of the tax year, typically December 31st. This is because Section 1231 gains have to be netted at the end of the year to determine if they are treated as ordinary income or capital gain. Only the capital gains portion can be re-invested.
Like Section 1231 gains, if an investor wants to re-invest gains from a K-1 investment in a partnership or S Corporation, the 180-day window will also begin on the last day of the tax year. There are some intricacies for investing capital gains from a partnership or S Corporation K-1 where the date can exceed 180 days from the taxable year-end. Once the 180-day window expires, the investor will be unable to invest the capital gain into an Opportunity Zone Fund.
Myth #5: It is easy for an investor to create and maintain an Opportunity Zone Fund
Opportunity Zone Funds have complex reporting requirements required by the federal government to ensure they follow required regulations stemming from the TCJA.
Each Qualified Opportunity Zone Business must have a written plan for each business in the fund. The written plan must detail how the cash will be used and it must be updated every six months. To maintain compliance with IRS regulations, Qualified Opportunity Zone Businesses must confirm bi-annually that 70% of their tangible assets in the business are Qualified Opportunity Zone properties. This threshold is bumped up to 90% if the properties are qualified at the fund level.
In addition, if any business purchases existing property in the Opportunity Zone, they need to show it made significant improvements to the qualified property within a specific timeframe.
There are more regulations to follow, but this article highlights a few of them to show the complexity of running an Opportunity Zone Fund. Although it can be difficult to create and oversee an Opportunity Zone Fund, it is relatively easy to invest in an already existing Opportunity Zone Fund managed by a third party.
Want to learn more about how Caliber selects its Opportunity Zone projects? Click here to learn more.
Caliber’s story is rooted in a set of investment principles that are now the company’s foundation. These principles were created naturally during our first formal year of operations, raising $18 million from investor-partners and buying, renovating, and selling over 150 single-family homes in 2009. Today, Caliber is growing to nearly $1 billion in assets under management or development.
Click here to see Caliber’s current property portfolio.
Caliber is the premiere wealth development company and fund sponsor in the Southwest, U.S.– focusing on projects that benefit individual and institutional investors, U.S. communities, and other environmental, social, and governmental initiatives. Caliber has an extensive history in managing numerous real estate property classes including commercial, hospitality, healthcare, and multi-family to name a few. The firm’s founders have decades of experience executing high conviction real estate strategies that generate attractive risk-adjusted returns. Caliber deploys a vertically integrated business model that develops wealth for its investors through various sponsored fund offerings.
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