Updated December 5, 2023
The 2017 Tax Cuts and Jobs Act created tax incentives to invest in designated opportunity zones. Its main purpose was to encourage economic growth and create jobs in low-income communities across the United States while providing tax benefits for investors. The law, which reduces and shields tax on capital gains, is meant to promote investment in more than 8,700 economically distressed communities across the U.S.
In this article, InvestmentNews provides some information investors can use to decide if they should invest in Opportunity Zones.
Financial advisers are welcome to share this piece with their clients to inspire a conversation on investment options like Opportunity Zones.
An Opportunity Zone is a tax incentive and a community listed by the state and certified by the Treasury Department as eligible for this program. This is meant to encourage those with capital gains to invest in a Low-Income Community (LIC) designated by the Tax Cuts and Jobs Act of 2017.
Under this act, all 50 states, the District of Columbia and five U.S. territories have designated Qualified Opportunity Zones. Taxpayers can invest in these zones through investment vehicles called Qualified Opportunity Funds.
Any corporation or individual taxpayer who has capital gains may invest in Opportunity Zones.
Qualified opportunity funds (QOFs) were created as part of the 2017 Tax Cuts and Jobs Act (TCJA). These funds were envisioned to encourage investment and development in distressed, low-income communities. For a community to be classified as an opportunity zone, it must first be designated by the state and certified by the secretary of the U.S. Treasury through the Internal Revenue Service.
How does a QOF come about? This is done by a corporation or partnership setting up an investment fund. It is then designated as a QOF by filing IRS Form 8996. The fund must then invest at least 90% of its assets in designated opportunity zones to receive the appropriate tax benefits.
Opportunity Zones were first created under the 2017 Tax Cuts and Jobs Act, signed into law by President Donald Trump.
When this law was enacted, Senators Cory Booker and Tim Scott, along with Representatives Ron Kind and Pat Tiberi, proposed the first Opportunity Zones. The law also garnered the support of Sean Parker's Economic Innovation Group. According to the act, states can designate up to 25% of low-income census tracts as Opportunity Zones.
The first zones were designated in April 2018, encompassing around 8,768 zones in all 50 states and 5 U.S. territories including American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands. The IRS maintains a list of these zones.
When putting money into Opportunity Funds and thereby investing in Opportunity Zones, the investor can enjoy these tax benefits:
Apart from these tax benefits, QOFs can also serve as another way for investors to diversify their portfolios outside of stock and bond markets. With QOFs, they can branch out into real estate investments or startup businesses.
Investors can invest in single-asset investment opportunities or multi-asset funds that invest in a collection of properties or businesses. These are often spread across different asset classes or geographies.
Since they were introduced in 2017, Opportunity Zones and the tax benefits associated with QOFs have received their fair share of criticism.
One of the main caveats: for investors to enjoy the full tax benefit, they must have invested in Opportunity Zones by the end of 2019. As not all zones offer good deals, such a deadline could mean that advisers and clients have had to rush into a less-than-lucrative investment.
Some years back, Opportunity Zones didn’t strike a chord with some potential investors. One adviser at Sequioa Financial, Leon LaBrecque, had this to say: “The deals haven’t worked out to be that great, I was really excited with [opportunity zones] when they came out. But I haven’t seen a good enough deal come across my desk yet that made me get excited.”
Another drawback is that the deferred tax comes due by December 31, 2026, a full seven years from the end of 2019. This means that clients who invest in an opportunity fund in 2020 or later will not be able to get the maximum 15% tax reduction.
On the side of the community, Opportunity Zones also make a negligible contribution to job creation. This video shows how some zones experienced little change in their economic situation:
The final potential drawback is that the investor only has 180 days from the sale of the original security to invest in an opportunity fund and reap the benefits of the tax break.
Investing in an Opportunity Zone with a QOF has its share of pros and cons. Here’s what investors should know before they invest:
When selling stock, real estate or a business, the capital gains from the sale are subject to taxes. Capital gains can be moved into a Qualified Opportunity Fund (QOF) within 180 days of the sale.
Here are the other tax benefits of a QOF:
The official regulations on Opportunity Zones can be challenging to understand, but complete compliance is crucial to maximizing this investment.
Investments must occur through a QOF, which must be a partnership or corporation for tax purposes, with the ability to self-certify. Other regulations include:
Establishing a QOF from the ground up can be a huge undertaking. Apart from having to understand Opportunity Zone compliance, investors should adhere to SEC guidelines if raising capital from outside sources.
This will also involve making private placement memorandums, subscription agreements, operating agreements and more. When deciding to invest in an existing QOF, investors will need to understand the experience of the team, its investment proposal, and track record.
Any investment should go through a due diligence process. A word of advice to investors: never decide haphazardly and invest purely for tax incentives. A good real estate investment does not always make a good Opportunity Zone investment. Acquiring a property that is fully leased to long-term tenants at a great value is the goal of many real estate investors.
For that deal to be Opportunity Zone-compliant, the property would need substantial improvement. This means that the fund would have to exceed their basis less the value of the land within a 30-month period.
Choose Opportunity Zone properties with deferred maintenance, excess land for future expansion, or properties that could be redesigned for new developments.
It is crucial that investments be located within a qualified Opportunity Zone to get the full tax benefits. With more than 8,700 throughout the U.S., investors should take the time to look for good zone locations.
Every Opportunity Zone is unique and comes with its own attributes that make it more appealing to different investors. Investors should decide first which metrics are vital, then research the data on those metrics to make informed decisions.
Don’t limit decisions to current metrics. Consider future growth and its impact on investment returns over time. For an idea of future growth in the zone, consider:
The main motivation behind Opportunity Zones legislation is to create a positive impact in low-income, distressed communities. As an investor, it can be fulfilling to see capital growing in a QOF while fostering economic development in distressed communities.
The potential positive long-term effects an investment can make include:
Given all the information, is an Opportunity Zone a viable investment opportunity for investors?
On the upside, there’s some proof that Opportunity Zones can uplift distressed communities like those in Birmingham and Detroit. You can see it in this video:
Depending on the location, characteristics, and potential gains, an opportunity zone can be a good investment. The tax benefits they offer also cannot be ignored.
However, as with any venture, investors should first practice due diligence, gather the information, then decide if it’s worthwhile.
Opportunity funds are new to the industry, and the administration that introduced them is no longer in office. This means that the rules, regulations, and taxation of these funds can be subject to change in the near future. Interested investors should do their homework and consult experienced tax and investment professionals.
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