The appeal of OZs is that for investors in specific situations, they can provide significantly beneficial tax benefits. The following is brief overview of Opportunity Zones to provide you with a better understanding of what happens to your money after making an Opportunity Zone investment.
What are Opportunity Zones?
In order to incentivize construction in underprivileged localities across the nation, over 8,700 Opportunity Zones were designated via the 2017 Tax Cuts & Jobs Act.
Benefits Conveyed with Opportunity Zones
When an investor sells a property and that transaction leads to an increase in income for the investor, that profit is referred to as capital gains. For investors that have recently received capital gains, they can reinvest that asset in an Opportunity Zone Qualified Fund (OZQF)—a pool of money earmarked for revamping properties located in these impoverished communities—or an individual property located in an Opportunity Zone. Here’s a rundown of the benefits of doing so:
Decrease Tax Liability
Reinvesting capital gains in properties located in OZs or in OZQFs and holding them for five years will result in substantial tax breaks. However, keep in mind that OFs were intended for long-term holds, and the benefits won’t be realized until five years after the initial investment is made.
Tax Basis Advantages
Assuming the investment in the OZQF or OZ property is not sold or exchanged, up to 15% of the initial gains invested will remain tax deferrable when they are claimed, on top of any interest that has accrued.
External Investments Possible
If your capital gains are directed to an OZQF, 90% of the funding is required to be exclusively invested in OZ properties. The other 10%, however, can be invested in non-OZ assets such as in new or preexisting businesses or corporate expansions.
Opportunity Zone Requirements
In order to receive the associated benefits of an Opportunity Zone investment, you’ll need to fulfill the following threshold requirements:
Regardless of whether you opt for an OZQF investment or to invest in a property located within an OZ, you are only afforded 180 days following receipt to select where to reinvest your capital gains.
Although your first investment can be reserved for alternative purposes, all your capital gains must be reinvested in order to qualify for the OZ benefits. To illustrate, if you accrue $30,000 in capital gains on August 1, 2020, you are required to invest the entire $30,000 in a qualified asset within the 180-day deadline referenced in the previous point in order to receive OZ tax breaks.
The total purchase price of the asset must be invested into the rehabilitation and development within 30 months of acquiring it. For example, if you purchase a property for $5 million, you must invest an additional $5 million into improvements within the initial two and a half years. While an existing structure can be acquired and rehabbed, in the majority of situations, investors looking to reap the benefits of OZ investments will be looking for developable land that they can build out and keep in their portfolio before eventually selling it for a substantial profit later down the road.
Words of Warning
While OZ and OZQF investments have great potential to realize a variety of benefits, keep in mind the following common pitfalls that could complicate the process.
Limited Historical Data
There is often a very limited amount of information on past development projects or property because OZs are typically new and do not have a lot of data from which trends may be examined. The associated homes or developments may still be being worked on or being rehabbed.
Rigid Accounting & Organization
Although a passive, long-term investment role with deferred taxes on capital gains may sound like the perfect scenario, there are strict mandates for the organization and accounting of the fund. Based on the size of an individual transaction, the associated costs of these legal and accounting services can add up and impact your bottom line.
Do Your Homework
While OZ investments are a great opportunity for certain investors ideally positioned, every individual considering them should conduct their own research. All developments you are considering becoming involved with should be thoroughly vetted to determine if the pending real estate undertaking has the requisite amount of value and viability to be sustainable.
Opportunity Zones provide a valuable investment opportunity for savvy investors, but they are not without risks, regulations, and mandates. It is important to take the time to research and consult with counsel to ensure your potential developments fulfill the obligations required to qualify for the incentives.