Find out how to defer capital gains taxes and earn higher returns with the right Opportunity Zone Funds
If you generated profits from the sale of almost any assets in 2019 (e.g., commercial and residential real estate, stocks, bonds, businesses, artwork, cryptocurrency… even baseball cards!), now is a good time to consider how you can reinvest the proceeds to reduce your capital gains tax exposure.
You have probably heard of a few options, such as the 1031 Exchange for real estate investors. However, they often come with requirements or restrictions that make it challenging to take advantage of the tax benefits.
Since December 2017, investors have had access to another option that’s more flexible and offers more tax benefits. By investing in Qualified Opportunity Zones (QOZ), you can enjoy a tax deferral while also reducing the amount of tax owed and eliminating future gains.
This article will show you everything you need to know about investing in Qualified Opportunity Funds so you can take advantage of these opportunities to maximize the tax benefits.
What is the Opportunity Zone Program?
The Opportunity Zone program was introduced in December 2017 as part of the Tax Cuts and Jobs Act. It’s designed to incentivize investments into housing, small businesses, and infrastructure in economically-distressed communities called Qualified Opportunity Zones (QOZ).
The program allows U.S. investors to defer all capital gains taxes for up to eight years from the enactment of the legislation as long as they invest (or reinvest) the profits into a Qualified Opportunity Fund (QOF) , which enables them to defer paying any capital gains tax due on the original investment until through December 31, 2026.
The capital gains tax owed will be decreased by 10% if the QOF investment is held for at least five years. In addition, investors will be exempt from any capital gains tax on any future profits from the QOF investment if the fund is held for ten years.
This means that for QOZ investments made in 2020 and 2021, you’ll receive a 10% reduction on the tax due if you hold them through the end of 2026.
Qualified Opportunity Funds (QOF)
A QOF refers to a corporation or partnership created for investing in QOZs. It has to meet the following guidelines:
- The fund must be certified by the U.S. Treasury Department or self-certified by completing a self-certification form per the IRS’s guidelines.
- The fund must hold 90% of its assets in a specified QOZ. If the fund is used to invest in properties, they must be placed into service in a QOZ for the first time or substantially improved by the QOF (or QOZ business) within a 30-month period to pass the “90-percent Test.”
There are three main types of qualified investments:
- QOZ business property: The purchase of tangible properties in a QOZ for trade or business purposes. This includes real estate as well as equipment and other tools that are used to run a business in the targeted zone.
- QOZ stocks: The purchase of stocks in companies located in a QOZ, which provides equity directly to the company.
- QOZ partnership interest: Investment in a partnership’s interest of a QOZ business that has all of the tangible properties owned or leased located in the QOZ. It also needs to earn at least 50% of its gross income from the active conduct of a trade or business in the QOZ.
Opportunity Zone Map
Investors can obtain more information about Opportunity Zones by using the interactive map created by the Economic Innovation Group. It allows you to search for specific places or addresses and get basic information such as population, median household income, percent of households in poverty, jobs, and more to better understand each Opportunity Zone.
The Benefits of Investing in Opportunity Zones
Besides helping distressed communities get the appropriate economic stimulus, QOZ Funds also offer many tax benefits to investors:
- You can defer capital gains taxes and qualify for a step-up in basis depending on how long the QOZ investment is held.
- You only need to reinvest the gains from the sale of the original asset instead of the entire proceeds to be eligible for the Opportunity Zone program tax benefits.
- You can roll the profits from the sale of almost any capital asset including real estate, stocks, bonds, precious metals, businesses, cryptocurrency, artwork, etc. into a QOZ fund.
- You can choose from many different types of eligible businesses to maximize your profits. For instance, you can invest in residential or vacation rental properties, which typically pose lower risks for investors.
It’s also easy to elect to take advantage of Opportunity Zone treatment—you simply complete a two-page Form 8949 when filing your tax return.
Here is an example that illustrates how you can significantly increase returns by investing in a QOF:
Let’s say an investor sold a real estate property for $450,000 (which he bought for $200,000) and generated a capital gain of $250,000. He’s a single filer living in Miami, Florida with just under $500,000 of ordinary income in the 2019 tax year. With a 23.8% effective tax rate (20.0% federal long-term capital gains rate plus 3.8% NIIT), he’d have to pay nearly $60K in taxes.
However, if the investor rolls over the original investment plus earnings (total $450,000 from the sale into Plaza Colón Hotel & Suites, Lifeafar’s first Qualified Opportunity Zone project in Puerto Rico with a projected IRR of 19.2%, and holds the asset for ten years, he would net total earnings of $1.4M in ten years including the asset sale proceeds and of that owe just $51K in capital gains tax. This translates into $1.8M in total cash returned, taking into account the initial invested capital.
How to Find the Best QOZ Investment
While Opportunity Zone program offers many tax benefits, the various rules and regulations can make investing in a QOF complicated for the average investor. For example:
- Investors need to comply with the strict IRS 180-day reinvestment rule by reinvesting their profits within 180 days of the sale of an asset to an unrelated third party. The short timeline, coupled with the often limited choices of investment opportunities, could pressure investors into making hasty decisions.
- Since the majority of Opportunity Zones are economically-distressed areas, many developers are promising returns in the 4-6% range, which isn’t particularly attractive compared to other types of investment vehicles. Investors will, therefore, need to put in the time and effort to look for high-yield opportunities to optimize the tax benefits.
- While the Opportunity Zone Map provides basic information about the QOZs, it doesn’t offer insights into many important factors that can impact the future economic potential of an area. Investors are often left to their own devices to find areas that demonstrate high growth potential despite the designation.
How to Find an Optimal QOZ Investment Opportunity
To get the most of your investment, you should look for well-managed QOFs that offer low-risk and high-return.
Invest in well-managed QOFs
QOFs are managed by QOZ sponsors, which are entities established to operate and oversee the inner-workings of a fund. The ability of a sponsor to properly manage the fund will have a significant impact on its performance.
Since the Opportunity Zone program is relatively new, many sponsors will be using their past experiences in similar types of investments and applying them to the management of the QOFs.
As such, you should look for sponsors/managers that have an established track record in the sub-markets or property types in which the fund is investing. They should demonstrate a high level of adaptability and the ability to apply their expertise to maximize your benefits.
A reputable sponsor/manager should provide you with information about the underlying investment and where your money will be directed. They should help you understand the downside risks, explain various scenarios (e.g., what could happen if the QOF doesn’t raise enough money or dissolves before a specified timeline), and discuss the potential penalties for early withdrawal.
You should also do your due diligence and ensure that the fund is and remains certified. Otherwise, you may have to pay the capital gains taxes you are trying to defer, plus any penalties that may be assessed.
Invest in locations with high growth potential
Since the QOZ program is designed to stimulate local economies in distressed areas, it can be hard to find investment opportunities that are low-risk and high-return. To maximize your benefits, it’s important to identify locations with tremendous growth potential despite their designation.
To do so, you should look beyond the Opportunity Zone Map to understand the economic potential of these regions. For example, 99% of Puerto Rico’s beachfront is designated as QOZ (including some of the best beaches in the Carribean). With the favorable acquisition costs and a growing vacation rental market, total returns for real estate investments in the area can reach 15-20% before accounting for the individual Opportunity Zone program tax benefits.
Invest in low-risk, high-return assets
While there are many different assets you can invest in via QOFs, real estate investments are one of the best choices as they are often high yield and low risk. For example, purchasing older buildings in Opportunity Zones where property values are low, and opportunities exist to renovate them to increase their future sale value while providing current rental income is a proven way to generate consistent passive income with minimal downside and strong tax benefits.
Make sure to invest in high-quality real estate assets in locations with a high growth potential so you can maximize your gains. For example, look for packaged investment opportunities that enable you to choose from a variety of investment structures that suit your investor profile and available funds.
Is Investing in an Opportunity Zone Fund Right for You?
Compared to many other investment vehicles, QOFs offer many tax benefits with few restrictions. They’re best for you if:
- You’re a passive investor looking to diversify your portfolio through professionally managed funds to minimize the time and effort you have to spend on managing the assets.
- You have capital gains from one or more appreciated assets and want the convenience of rolling all the profits into one investment vehicle while deferring and eliminating tax burdens.
- You want to retain access to the initial principal.
- You have a medium-term time horizon and want access to the capital gains from the original investment in a few years while paying a reduced capital gains tax.
Want to learn how to reduce your capital gains tax by investing in Puerto Rico?
Contact Lifeafar by filing out the form below to discuss current investment opportunities in Puerto Rico and how you can take advantage of the full Opportunity Zone benefits by investing in projects with a projected pre-Opportunity Zone investment IRR of 16-19%.
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