This article seeks to familiarize investors with some of the common questions about opportunity zones and qualified opportunity zone funds. Interested investors are encouraged to reach out to our team for specific details on our fund offerings as well as contact their tax, legal, and financial professionals for guidance on their specific circumstances to determine the suitability of opportunity zone investing.
What is a Qualified Opportunity Zone?
A Qualified Opportunity Zone (QOZ) is a designated geographical area where investors can develop real estate projects with the opportunity to obtain significant tax advantages. QOZs are typically located in economically underprivileged communities across the United States.
How were Qualified Opportunity Zones created?
The opportunity zone provision was a part of 2017’s Tax Cuts and Jobs Act. Since then, investor interest has grown substantially. As of Q3 2021, there are over 1,200 funds targeting investor capital for opportunity zone investment, with an estimated $152.2 billion raised through Q4 2021.
Investor interest isn’t surprising, given the potent pairing of significant tax benefits on current capital gains and the potential for tax-free capital appreciation offered by opportunity zones.
What is a Qualified Opportunity Zone Business?
According to LISC, To qualify as an eligible Opportunity Zone Business, a business must demonstrate, that substantially, all its tangible business property is located within a Qualified Opportunity Zone. Currently, there are no rules regarding the service area of the Opportunity Zone Business in the statute, but the guidance and regulations could be subjected to change by the IRS in the future.
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There are various approaches utilized by Caliber, such as converting commercial spaces, investing in distressed real estate, and introducing pickleball facilities. In this podcast, Chris discusses the importance and intricacies of approaching opportunity, building investor trust, securing funding, transitioning to the public domain, and maximizing returns within Opportunity Zones.
How do I invest in a Qualified Opportunity Zone?
To invest in a QOZ, investors must transfer eligible cash or property to a Qualified Opportunity Fund (“QOF”).
Per the IRS, a QOF is “an investment vehicle that files either a partnership or corporate federal income tax return organized for the purpose of investing in QOZ property.[1]” In other words, funds created by investment firms to provide investors a way to access QOZ properties.
Generally, outside investors join as limited partners after completing several legal documents, including the subscription agreement and private placement memorandum. These documents outline the fund’s terms, including ownership, the scope of the portfolio, payout terms, and more. The fund’s management company, legal, or compliance department may require additional documentation.
“Eligible cash or property” is the key phrase here. Eligible gains include those treated as capital gains for US federal income tax purposes. In a detailed post on the subject, lawyers for McDermott Will & Emery detail which gains are considered eligible, including: “gains from the disposition of capital assets… the disposition of Section 1231(b) property, and other forms of income treated as capital gain under the Internal Revenue Code.” They go on to state that “gains from the disposition of real property, stock, cryptocurrency, artwork and many other types of assets may be invested into a QOF.”[2]
What is the Opportunity Zone 180-day Rule?
One of the benefits of investing in a Qualified Opportunity Fund (QOF) is the ability to temporarily defer taxes on eligible capital gains. Taxable gains invested in a QOF are not recognized until December 31, 2026 (due when you file your 2026 tax return or extension in 2027), or until the interest in the QOF is sold or exchanged, whichever happens first. To defer tax on an eligible gain, you’ll generally need to invest in a QOF within 180 days of realizing the gain. The first day of the 180-day period is the date the gain would be recognized for federal income tax purposes if you didn’t elect to defer the gain. When it comes to K1s and 1231s, the rules differ just a bit. Click the hyperlink above to learn more about the 180-day rule in Qualified Opportunity Zone investing for individuals and business entities.
Let’s look at a simple example: Say you sold some stock for an eligible capital gain. Your 180-day period begins on the date of the sale. If you invest all or part of the eligible gain in a QOF during the 180-day period, you may elect to defer the tax on that amount.
What are the benefits of investing in Qualified Opportunity Zones?
There are three significant benefits to investing in a QOF:
- Deferred capital gains: Investors defer their federal capital gain tax obligation from the sale of the eligible property until December 31, 2026, if the investor transfer the gains to a QOF within 180 days from the date of the sale or exchange of the property.
- Avoided tax on 10-year investments: Gains derived from investing in the QOF are excluded from any US federal taxes if the investor holds their interest in the QOF for 10 years or longer. Under current regulations, there is no limit to the amount of gain excluded from tax.
- Tax-free Distributions: Investors can refinance their investment and take a distribution without being subject to immediate federal tax liability during the 10-year holding period.
For example, suppose an investor invests $1 million of eligible capital gains into a QOF. The investor holds their interest in the QOF for ten years before disposing of the position. What has happened?
First, the investor defers paying tax on the initial $1 million until December 31, 2026 or the QOF investment is sold, whichever comes first. Second, the investor avoids taxes the QOF generates on any earned or lost gains of the $1,000,000 invested.
How are Qualified Opportunity Zones regulated?
State governors nominate communities that qualify as QOZs; the Secretary of the US Treasury, via their authority, authorized by the Internal Revenue Service (“IRS”), then certifies the nomination, creating a designated QOZ.
To be eligible for the QOZ designation, the law specifies that census tracts must be in low-income communities (“LIC”) or non-LIC contiguous tracts. For the purposes of the QOZ designation, the law considers a community a LIC if[3]:
- The community poverty rate[1] equals or exceeds 20%
- The median family income does not exceed 80% of statewide median family income or the metropolitan area median family income, whichever is higher.
A non-LIC contiguous tract is those both adjacent to a LIC designated as a QOZ and had a median family income of no more than 125% of the adjacent LIC.
Nearly 9,000 census tracts received the QOZ designation[2] out of over 41,000 eligible tracts.[3] Search for an address, census tract, or other geographic areas of interest here.
Commonly, private equity firms offer QOFs, which are required to register as investment advisers if firm assets under management exceed $150 million.
Eligible corporations or partnerships self-certify their QOF status each year by filling out form 8996 along with its federal income tax return. Visit the IRS’s form 8996 instructions page for more details.
Common Misconceptions about Qualified 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.
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.
Myth #3: 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.
1231 Gains
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 reinvested.
K-1 Investments
For K-1 investments, there are three different time frames that may initiate the 180-day investment window. These are:
1. The date of the entity’s tax year-end (usually December 31st)
2. The date of the actual gain
3. The original due date (not including extensions) of the flow-through entity’s return
Consult with your tax professional to determine the action appropriate for your specific circumstances.
Myth #4: 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.
Sources
[1] https://www.irs.gov/credits-deductions/opportunity-zones-frequently-asked-questions#designated
[2] https://www.mwe.com/insights/how-to-invest-in-a-qof/.
[3] https://www.gao.gov/assets/gao-22-104019.pdf
[4] The poverty rate is the ratio of the number of people whose income falls below the poverty line. As of 2020, the guideline poverty rate is $12,760 for a household of one.
[5] https://www.scott.senate.gov/opportunityzones
[6] https://www.cof.org/content/cdfi-fund-map-all-census-tracts-eligible-designation-qualified-opportunity-zone
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About Caliber
Caliber – the Wealth Development Company – is a middle-market alternative asset manager and fund sponsor with approximately $2 billion in assets under management and development. The Company sponsors private funds, private syndications, as well as externally managed real estate investment trusts (REITs). It conducts substantially all business through CaliberCos, Inc., a vertically integrated asset manager delivering services which include capital formation and management, real estate development, construction management, acquisitions and sales. Caliber delivers a full suite of alternative investments to a $4 trillion market that includes high net worth, accredited and qualified investors, as well as family offices and smaller institutions. This strategy allows the Company to opportunistically compete in an evolving middle-market arena for alternative investments. Additional information can be found at CaliberCo.com and CaliberFunds.co.
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If you would like to speak to someone about diversifying your retirement accounts, contact us at [email protected] or call (480) 295-7600 to schedule a call with a member of our Wealth Development Team.
If you would like to learn more about Opportunity Zone Investing, Caliber has put together a special guide that cuts through the myths and misconceptions and outlines the benefits, the risks, and the upcoming deadlines you must know to be able to participate. Get access to the guide here.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
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