In every state, there are areas that investors often avoid. These might be areas where a once-booming industry has declined, leaving behind shuttered factories or abandoned warehouses. They might be areas that were neglected for generations and have little foot traffic or housing options. They can be urban, suburban, or rural areas that simply lack services or have few new businesses.
Investing in these communities can help bring them back to life. To encourage investors to consider putting their dollars into these areas, the government in 2017 incorporated “opportunity zones” into the federal tax code.
Investing in an opportunity zone, which can carry significant tax advantages, must be done following a specific process, and if you don’t know the rules, you could be leaving money on the table. We spoke to Doug Keith, an SBF CPA who has worked extensively with clients who have invested in opportunity zones, to get answers to some frequently asked questions about opportunity zones. If you have more questions, or would like to get started with an SBF advisor, email us at firstname.lastname@example.org.
Exactly what is an opportunity zone?
Every state and territory designates certain economically distressed communities as “opportunity zones,” which are certified by the U.S. Treasury Department. Some types of investments in these areas may be eligible for tax incentives, which are given to stimulate the economy of these communities by creating jobs or bringing in new services.
How do you invest in an opportunity zone?
- The process starts with using a capital gain. Only a re-investment of a capital gain will qualify for the tax benefits of an opportunity zone. The investment can be all or a portion of the gains. (Note that a taxpayer can invest money that isn’t from a capital gain into an opportunity zone, but this is considered a non-qualified investment and receives none of the tax benefits related to opportunity zones.)
- The investment must be made into a qualified opportunity fund (QOF). That could mean investing in a QOF established by others, or creating your own QOF. If you are setting up your own group, the QOF must be treated as a partnership or corporation for federal income tax purposes. On the first tax return you file for this investment, you will need to indicate that you are forming a new QOF.
- Generally, the investment must be made within 180 days from the date the capital gain was realized, though there are exceptions for some specific situations related to corporations.
What factors should an investor or business owner weigh when they’re considering an opportunity zone investment?
- First, to take advantage of what is potentially the biggest tax benefit, you have to hold your QOF investment for at least 10 years, so you need to be comfortable with an investment of that length of time. There are some shorter-term tax benefits in an OZ investment, but to take full advantage, it should be for at least 10 years.
- A QOF must operate a qualified business, a QOZB. There are a number of requirements for both a QOF and a QOZB to qualify for the tax benefits of an opportunity zone. Even a passive investor (someone who is investing into someone else’s QOF, not starting their own) should have some understanding of these requirements to ensure that those they are investing with are operating things properly.
- The opportunity zone business must be a trade or business as defined by IRC 162, meeting the objective of bringing economic development and job creation to these distressed areas. The regulations have an anti-abuse clause giving the IRS the power to terminate opportunity zone status in cases where the IRS feels the activity is attempting to circumvent the defined objective.
- To be qualified for opportunity zone treatment, an asset must be new to the zone or must involve an existing building that is substantially improved within a defined period. Careful planning is required to make sure there is enough investment to make necessary improvements and/or purchase new assets.
- There is an ongoing test to make sure investment standards are met. A QOF must keep at least 90% of its assets in qualified opportunity zone property, and a QOZB must have at least 70% of its tangible assets in qualified property.
- If you are thinking about investing in property within an opportunity zone, keep in mind that the sellers have likely increased their selling price knowing that an investor is factoring in the tax incentives.
Generally, what are the tax benefits of an opportunity zone?
There are three different possible tax benefits: deferral, reduction, and possible elimination of gain.
Deferral of capital gains taxes. An investor who re-invests capital gains within six months of realizing the gains into a Qualified Opportunity Fund (QOF) may defer paying federal taxes on those realized gains until as late as December 31, 2026.
Reduction of capital gains taxes. Holding an investment in an Opportunity Fund for at least five years can reduce an investor’s tax bill on the deferred capital gains by 10%. This reduction increases to 15% after holding the investment for seven years.
Elimination of taxes on future gains. An investor holding an investment in an Opportunity Fund for at least 10 years will not be required to pay federal capital gains taxes on any gains realized from the investment in the Opportunity Fund.
What are the risks of an opportunity zone investment?
That’s a great question, because taxpayers should not jump into this type of investment simply for the tax benefits. Yes, the tax benefits can be significant, but just like any other investment, it can fail, so taxpayers should do their homework and make sure they are comfortable with what they are investing in and who they are investing with.
There are also other risks that are specific to opportunity zones. A QOF is subject to penalties, and potentially forfeiture of its opportunity zone status, if the money invested is not used properly according to the various opportunity zone rules. Also, the initial gain deferral on an opportunity zone investment is not locked into today’s capital gain rates. If there is a statutory increase in capital gain rates for the year the gain is ultimately recognized, the taxpayer will be paying tax according to those rates.
Is there anything folks should know about opportunity zones related to the COVID-19 pandemic?
Yes, there are several areas in the opportunity zone timeline that have been granted relief due to COVID-19.
- If taxpayers’ 180-day clock for investing in a QOF terminates between April 1, 2020 and December 31, 2020, the relief allows them to extend it until December 31, 2020.
- There is a 90% investment standard that QOFs must meet twice every year. The COVID-19 relief legislation added a reasonable cause exception that failure to meet 90% between April 1, 2020 and December 31, 2020 will be considered due to reasonable cause and no penalty will be assessed.
- All 50 states have been declared federal disaster areas due to COVID-19. This allows QOZBs to extend the amount of time they are allowed to take advantage of the working capital safe harbor for any asset held before December 31, 2020.
- There is a rule that if a QOF sells assets, it has 12 months to re-invest the cash from that sale into qualified opportunity zone property without affecting the QOF’s status. The IRS has granted an additional 12 months for instances when the original 12-month period included the date January 20, 2020.
How do potential investors figure out where opportunity zones are in the Tampa Bay area?
Opportunity Zone boundaries are defined by census tracts. The IRS keeps the official list of OZ census tracts, which can be found here. Finding an address using just a census tract number can be cumbersome, so fortunately there have been a number of online tools developed to search by address. Here are a couple of them:
When using these tools, always cross-reference the census tract number to the official IRS list to ensure your findings are accurate.
There are more than 400 opportunity zones in Florida, with at least one in each county, according to the Tampa Bay Times. One example of an opportunity zone investment in our area is Tampa’s urban renewal project, Encore, at the former location of the Central Park Village housing development.
What are some misconceptions people have about opportunity zones?
One common misconception we’ve come across a number of times is the assumption that if a property or business is already located within an opportunity zone, this would be a great benefit to the owners. Unfortunately, this is not generally the case. Qualified assets must be new to the zone or involve substantially improvement to a property. So, while an existing business could possibly qualify, it would take a large investment into that business to meet the 90% and 70% tests.
Another misconception is that once a QOF has started, everything that happens within that business is tax-free. The opposite is true; everything that occurs within a QOF is business as usual as far as federal taxes are concerned. The tax benefits come from the upfront investment (deferral and possible reduction of a capital gain), and the gain elimination that comes from selling the QOF investment after 10 years. For everything in between, an investor will either pay tax or receive a K-1 as they would with any other business.
Lastly, we have seen confusion over the tax benefits of the original deferred gain that is invested into a QOF. Some clients have thought that original deferred gain is eliminated if they hold the investment for more than 10 years, however, that gain must be recognized before the end of 2026 or the date the taxpayer sells the QOF interest. It’s the gain on their new OZ investment that would be eliminated if held for 10+ years.
If you’re considering investing in an opportunity zone, it’s clear you need tax advice (and SBF is here to help!), but who else should be on your team?
We often recommend having a team that includes SBF for tax planning, along with a real estate lawyer and commercial real estate professional who have experience in working with opportunity zones. SBF can help with referrals if needed.