Opportunity Zones are a type of economic development strategy that allows people to invest in economically challenged areas of the US. Their goal is to help low-income communities prosper and create jobs while also providing tax breaks to investors. The 2017 Tax Cuts and Jobs Act established Opportunity Zones (Public Law No. 115-97). Thousands of low-income areas have been designated as Qualified Opportunity Zones in all 50 states, the District of Columbia, and five US territories. Qualified Opportunity Funds allow taxpayers to invest in these zones.
Qualified Opportunity Zones
A Qualified Opportunity zone is an economically challenged community where new investments may be eligible for special tax treatment under specific conditions. Localities qualify as QOZs if they were nominated for that designation by a state, the District of Columbia, or a United States territory, and that nomination was confirmed by the Secretary of the United States Treasury via his delegation of power to the Internal Revenue Service (IRS).
Census tracts required to be “low-income” to be considered an Opportunity Zone. To do so, the census tract had to meet at least one of the following criteria:
A poverty rate of at least 20% exists in the tract; OR
(A) The median family income of a census tract in a metropolitan area does not exceed 80% of the greater of the metropolitan area median family income or the statewide median family income; or (B) the median family income of a census tract in a non-metropolitan area does not exceed 80% of the statewide median family income.
If the census tract is in a high-migration rural county, however, it qualifies as low-income if it does not surpass 85 percent (rather than 80 percent) of the statewide average.
Investments in opportunity zones receive special tax treatment so investors can reinvest their capital gains without including them in their taxable income. However, It’s the long-term investment that offers the most benefits. Specifically, opportunity zone investments can permanently exclude their earnings from taxable income provided the investor holds them for a minimum of ten years.
Yet, some opportunity zones will prove more lucrative than others. As not all opportunity zones are created equal.
While the prospective tax benefits of an investment are appealing, they cannot compensate for a poor real estate investment. At the best of times, property development entails significant risks. Investors should keep in mind that opportunity zones are defined as regions where development has not occurred naturally. According to National Real Estate Investor, investments in numerous opportunity zones can have higher risk profiles.
Investors in opportunity zones must keep in mind that these are still real estate investments first and foremost. Consequently, real estate developers and investors must analyze each transaction based on the fundamentals of the property.
For opportunity zone investors, competition is posing its own set of problems. Due to fierce competition among qualifying opportunity funds and a tiny number of truly high-quality properties in the economically distressed areas covered by opportunity zones, good deals are difficult to come by. According to the The Wall Street Journal, this, along with an obvious fear of losing out, has resulted in developers and investors buying now and planning for the future later.
It’s rarely a good idea to go headfirst into an expensive, long-term real estate venture.
To make a profit, a taxpayer must sell an asset and realize a capital gain. The capital gain is then invested in a Qualified OZ fund by the taxpayer. Finally, there is a delay and reduction in taxes owed to the government — if held for ten years, the taxpayer can pay no capital gains tax on the new investment in the fund.
Eligible Gain Deferral
The term “eligible gains” refers to gains that can be deferred. This includes both capital gains and qualified 1231 gains, but only those allocable to federal income tax before January 1, 2027, and not from a transaction with a related person. To qualify for this deferral, the eligible gain amount must be invested in a QOF and exchanged for an equity interest in the QOF within the specified time frame (qualifying investment). Once this is completed, the taxpayer is entitled to claim the deferral for the taxable year in which the gain would have been recognised if it had not been for the deferral.
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Identifying the right opportunity zones
Thousands of zones have been designated as opportunity zones throughout the country, but few offer investing opportunities that are truly exceptional. Those zones with valuable opportunities for economic development as well as relatively easy paths to a broader community revival are the real gems. Many of these neighborhoods have already seen an urban revival after being designated as opportunity zones. A multibillion-dollar football stadium will soon be built in the Inglewood neighborhood, which should boost local economic growth. Investing in the nearby opportunity zones may provide investors with both secular growth and property-specific profits.
Identifying the best opportunity zones
Many opportunities zones have been designated across the country, but only a few have proven to be worthy investments. The real treasures are the areas that provide both valuable economic development potential and relatively simple avenues to broader community revitalization. A textbook illustration of such an opportunity can be seen in downtown Los Angeles. Several communities have been classified as opportunity zones, with several of them already undergoing urban revitalization. A multibillion-dollar football stadium is about to be built in the Inglewood area, which is intended to encourage local development. Investing in the surrounding opportunity zones may provide investors with the possibility to profit from both secular and property-specific development.
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What Are Opportunity Zone Funds and How Do They Work?
Active real estate investors establish various Qualified Opportunity Funds, whether through partnerships, limited liability companies (LLC), or corporations. The fund must file the necessary paperwork and follow IRS regulations. Any assets they invest in must be operational, abandoned, or undeveloped, and they must show significant improvement within 30 days of purchase.
Investing in Opportunity Funds requires you to transfer cash or property to a Qualified Opportunity Fund, according to the IRS. Due to the nature of noncash property, only a portion of the investment may be eligible for tax benefits. To receive the tax benefit, you must comply with annual investor reporting requirements and make your investment within 180 days of realising your capital gain.
Who can create an Opportunity Fund?
What types of businesses will be eligible to participate in a QOF?
Initially, QOZ business property must be used for a QOF or a QOZ business, according to the original use test (e.g., a newly constructed building). During the 30-month period following the acquisition of the property by the QOF, the basis in the property (excluding any land) may also increase by more than the adjusted basis at the time of acquisition.
Can inventory be considered QOZ business property?
Is it possible to classify inventory in transit as QOZ business property?
What gains are eligible for opportunity zones?
What types of profits may I defer if I put money into a QOF?
In an Opportunity Zone, how long do you have to build?
Is it possible to invest in opportunity zones without making a profit?
Benefits of Investing in Opportunity Zones
For investing unrealized capital gains in Opportunity Zones, the programme offers three tax benefits:
- Tax deferrals on previously earned capital gains for a certain time. An opportunity fund can be invested with existing assets that have accrued capital gains. There will be no taxation on existing capital gains until the end of 2026, or until the asset is sold.
- Investment of previously earned capital gains with a step-up in basis. Investors’ base on the original investment increases by 10% if capital gains are held in Opportunity Funds for at least 5 years. Investors’ base on the original investment improves by 15% if they invest for at least 7 years.
- New gains are permanently exempt from taxation. Investors in Opportunity Funds pay no taxes on any capital gains generated by their assets if they hold them for at least ten years (the investment vehicle that invests in Opportunity Zones).
Time limit for making investments in an Opportunity Fund
The IRS rule-making process determines this timeframe. According to the legislation, an Opportunity Fund may be required to invest 90 percent of its capital in Opportunity Zone Property within the first six months of the Opportunity Fund’s taxable year. The rulemaking process may include some timing relief to allow for a 12-month investment window. In order to receive the tax benefits, the investor must invest in an Opportunity Fund within six months of realizing the capital gain.
Why is there a 180-day deadline for making an Opportunity Zone investment set by the IRS?
How to avoid capital gains tax?
What happens if a company in Oz relocates? Is there a risk of recapture?
Is it possible for the Opportunity Zone Fund to borrow money?
Is it possible for an opportunity zone fund to invest in another opportunity zone fund?
Can Opportunity Zones be modified?
Is an accredited investor required to invest in opportunity zones?
Can an LLC invest in an Opportunity Zone?
Conclusion
Understanding capital gains tax is essential before investing. If you have significant capital gains, investing some of your cash or assets in an opportunity fund may be well worth it.
There are thousands of opportunity zones. Each state and territory has a different strategy for making them work. Furthermore, different Qualified Opportunity Funds operate in these zones. You should look into where your money is going and why it is going there.