Opportunity Zone Investing
Opportunity Zones are not a new thing to states and local communities; however, as part of the 2017 Tax Cuts and Jobs Act, the Federal government designated certain geographical areas as Qualified Opportunity Zones or QOZs. These areas are generally more economically distressed, therefore the idea is to create an incentive to invest and revitalize these areas via tax benefits. An interactive map of these Qualified Opportunity Zones can be found here.
How did the Federal Government Designate Qualified Opportunity Zones in each State and How Long will they Remain Designated QOZ?
The governors of each state recommended areas to be certified as QOZs, and the recommendations had to fall within the guidelines issued by the IRS. The major guidelines were:
- Up to 25% of census tracts in a state could be designated as an Opportunity Zone. You can view all the census tracts in all states here.
- Each census tract must have at least 20% poverty rate
- Median income for that census tract cannot exceed 80% of the metro or state level median income
The census tracts that were designated as opportunity zones will remain in effect through the end of 2028.
What are the tax benefits that have been proposed?
If you have the right investment capital, and the right opportunity, investing in a QOZ can be a powerful tax benefit. Here’s the highlights of the benefits:
- If you sell any asset type (real estate, stocks, business) and have capital gains on the sale, you may defer those gains if you place the gains within 180 days of realizing the gain. The added benefit is that unlike a 1031 exchange, you don’t have to invest ALL the proceeds from the sale that created the gain, so it’s much more flexible from that stand point.
- Additionally, If the investment is held for at least 5 years, the investor will receive a 10% reduction in the tax liability from the original gain. If held for at least 7 years by the end of 2026, the investor will receive a 15% reduction in tax liability from the original gain. And finally, if held for at least 10 years or beyond, gains from the investment in the QOZ (not including the original gain reinvested in the QOZ) will become completely tax-free.
Wow! This sounds like a 1031 Exchange on steroids! How can I start investing!?
Whoa cowboy. Not so fast. There’re some other critical requirements that may make you rethink whether this is right for you, especially if you’re considering buying an existing building.
- In addition to investing in a purchase of property in a QOZ, if you are buying an existing building you must “substantially improve” the property, which by IRS guidelines, that means you have to double the tax basis of the building (negating the value of the land). Again, the intent of the regulation is to generate quality improvements and developments in areas that typically wouldn’t receive this type of attention, so although perhaps a bit frustrating for a typical passive investor, it should drive the right type of investment to these areas.
- To receive the full benefit of these investments, an investor must hold for at least 10 years. That’s a long time if you are looking for a liquid investment or if you’re a developer who typically develops a property and then sells upon stabilization.
Ok, I’m a long term holder and I’m not afraid to get my hands dirty on improving a property – now what?
All investments must be made through a Qualified Opportunity Fund (QOF). While that may sound intimidating for some, it’s fairly simple. Any LLC or Corporation can self certify as an QOF using IRS form 8996. The main criteria is that at least 90% of assets of that entity are held in a qualified opportunity zone. The IRS doesn’t want companies or individuals getting these major tax benefits if they aren’t truly investing in a QOZ.
Now, if you’re like me, you learn by example. So here’s a simple example of how all this can play out.
Let’s say Investor A sells stocks in a company for $2,000,000 on January 1, 2019 and makes a gain of $1,000,000. Investor A takes the $1,000,000 gain and purchases an existing vacant office building in a QOZ by June 30, 2019 (within the 180 day timeframe for placement) using their newly formed Qualified Opportunity Fund. We’ll call this the OZ Investment. The property purchased has a building value of $500k and a land value of $500k. Over the next 30 months, Investor A puts in an additional $500k into the building to improve the exterior and common areas and lease it to stabilization.
How the Tax Savings Look:
- Sale of Stocks – Gain of $1M
- OZ Investment (Vacant Office Building) – $1M initial investment – deferring approx. $200k in tax liability from the Stock sale
- Additional Investment of $500k to “Substantially Improve” the building and meet the qualification of doubling the basis of the building within 30 months
- Total Basis of OZ Investment = $1.5M
Tax liability after 5 years if sold for $3M = (($1M original gain + 1.5M additional gain) x 20% (long term capital gains rate) x 90% (10% reduction in tax liability for holding at least 5 years) = $450k, a tax savings of approx. $50k.
Tax liability after 7 years if sold for $3M = (($1M original gain + 1.5M additional gain) x 20% (long term capital gains rate) x 85% (15% reduction in tax liability for holding at least 5 years) = $425k, a tax savings of approx. $75k.
Tax liability after 10 years if sold for $3M = (($1M original gain x 20%) + ZERO tax liability for the additional $1.5M in gain = $200k, a tax savings of approx. $300k.
As you can see. Long term holders can greatly benefit on a deals that are executed correctly.
There’s still a lot to learn about these investments and the guidelines have not been finalized by the IRS, so it’s important to have a team that can help serve as a guide while this regulation evolves and becomes clearer. It’s also important to note that just because a property is in a QOZ, it doesn’t automatically make it a good deal. We’re advising our clients to still evaluate each deal as if it were not in an QOZ. If it’s a decent investment, then this program will make it an even better investment without a doubt. If it’s a bad investment, this regulation doesn’t make it a good investment.
Cecil & Campbell Advisors are deeply in tune to properties both on and off market in Qualified Opportunity Zones. We would love to partner with you on finding the right property and to be a resource for your specific investment strategy.