What is a Qualified Opportunity Zone?

A Qualified Opportunity Zone (OZ) is a tax incentive created through the 2017 Tax Cuts and Jobs Act to encourage investment in designated lower income communities.  Therefore, an OZ is a designated geographic area, in which certain investments occurring in that area and that are compliant with other recently established rules, will receive attractive tax benefits.  The theory behind the OZ incentive is that the investment it attracts will improve economic development and activity in these communities.

What is a Qualified Opportunity Fund?

The Qualified Opportunity Fund (QOF) is exactly as it sounds.  It is typically a partnership or corporate entity created to pool assets. This pool can allow for improved diversification and liquidity when investing in OZs.  Of course, direct investment into property within these OZs is possible as well but may lack diversification and should only be engaged in by experienced real estate investors and developers. For most, the QOF may be a more prudent approach. All natural entities such as partnerships, corporations, individuals, LLCs and certain trusts or estates are permitted to partake in investing in OZs and will commonly do so through the fund structure.  To participate, the investing entity itself need not reside in the opportunity zone.

What is the benefit to investing in a QOF?

The most recognizable and attractive financial benefit to investing in a QOF is the potential for capital gain deferral, exclusion or elimination.  To reap these benefits, investors must follow stringent rules that lack judicial precedence given their new nature.

• A taxpayer who sells property to an unrelated person, and recognizing capital gains, can defer, exclude or potentially eliminate the capital gain entirely.  This is done by reinvesting the proceeds from the sale into a QOF within 180 days of the initial sale. Further, appreciation of investment in the QOF can also be avoided if certain conditions are met.  It is important to ensure that the sale of the initial property is not to a related person as defined by the code or in violation of any other stipulation or requirement.

• If the investment in the QOF is held for 5-7 years, the initially deferred gain can be reduced by 10%.

• If the investment in the QOF is held for more than 7 years, the initially deferred gain can be reduced by 15% in certain instances.

• QOF investments held at least 10 years may also be able to exclude any appreciation from capital gains that occurred while invested.

Key considerations

1. To engage in the deferral of income tax of up to 15% of the otherwise realized gain, taxpayers must recognize the 15% deferral by the earlier of December 31, 2026 or the sale of the investment.  Given that in order to enjoy the 15% deferral, the investment in a QOF be greater than 7 years, such investments must be made prior to year-end 2019.  Investments in QOFs in 2020 and beyond will not be able to benefit by the 15% because even if held for a long period, December 31, 2026 will arrive prior to the investment reaching 7 years.

2. For the gain exemption to be applicable, the investment in the OZ must be sold before 2048.

3. The gain must be recognized, not just realized.  So certain deemed sales that never actually occurred (corporate M&A for example) would not qualify.

4. There are no income limitations or requirements for taxpayers to work in certain industries to be able to participate.

5. The nature of the capital gain being deferred is preserved (short-term vs. long-term)

6. Similar to the popular strategy among Section 1031 rollovers, a QOF investment can be rolled from one QOF into another, deferring the initial gain, however the holding period for deferral and exclusion must start again upon rollover.

Buyer Beware

The appropriate opportunity to invest in a QOF is attractive to many real estate investors for obvious reasons. That said however, the cost to invest can in many cases be prohibitory. While it is not wise for most to directly invest in an OZ without being a very experienced and savy real estate investor or developer, the cost to investment in an alternative vehicle such as a real estate investment partnership can be expensive. While you are presumably paying for professional management and perhaps diversification exposure to a variety of different OZ’s within a single fund; management, incentive and other fees can erode much of the ultimate tax benefits if not properly understood before investing. With incentives in place for investors to rush into this strategy as soon as possible to capture tax benefits, many funds are more than willing to help put the pressure on. Further, only if the investor is willing to commit for a considerable period of time does an OZ investment make sense.

An Example

Jill Taxpayer owns XYZ stock with a cost basis of $40,000 and a market value of $50,000 on 6/30/2019.  If Jill sells XYZ on 6/30/2019, she would typically include $10,000 of capital gain in her 2019 gross income.  If Jill reinvests the $50,000 of proceeds into a QOF within 180-days she is not required to report the $10,000 gain in her 2019 taxes.  Instead, if Jill still holds her entire investment in the QOF on December 31, 2026, Jill may only need to include $8,500 in her 2026 gross income related to the initial sale.  Assuming Jill eventually sells her QEF interest in 2030 for $100,000, the $50,000 of appreciation would be excluded from her gross income.

The result is that rather than recognize $10,000 of gain initially, and likely pay a total tax of approximately $3,000 (assuming a 30% combined capital gains tax), then reinvest the $50,000 into something else that if it grew to $100,000 over 10 years she would have a tax liability of an additional approximate $15,000 when selling – totaling $18,000.  Instead, through the use of a QOF, Jill only ever paid approximately $2,500 - seven years after her initial sale, thus increasing overall wealth by $15,500 before considering investment performance.  If Jill’s QOF investment performs even better before selling, then the overall savings are even larger. Of course, as stated above, the existence of a QOF fund which may improve diversification and minimize risk, may also come at an expensive cost which must be understood.

Final Takeaway

This is a powerful and enticing opportunity.  However, it is crucial for investors to understand that they are investing in an area that is:

a) new to the tax code (for better or worse),

b) a low income community that comes with inherent investment risks,

c) potentially expensive and has restrictive investment cost structures, and

d) locks up capital for a long-duration. 

If an investor understands these crucial points in addition to the basic strategy, only then may an OZ investment become appropriate in our opinion. Any investment, especially one that is motivated by tax reasons of which the benefit stems from being illiquid and holding for a long period of time, must make sense from a business or investment perspective as a prerequisite to engaging this activity. We encourage readers of this article to contact their qualified tax, legal and financial professionals before implementing such a strategy. If you have questions on Opportunity Zones, please do not hesitate to contact us.

Disclosure: (“Hudson Oak”) is a registered investment adviser in the State of New Jersey. For information pertaining to Hudson Oak’s registration status, its fees and services and/or a copy of our Form ADV disclosure statement, please contact Hudson Oak. A full description of the firm’s business operations and service offerings is contained in our Disclosure Brochure which appears as Part 2A of Form ADV. Please read the Disclosure Brochure carefully before you invest.

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NOTE - This article also appeared on www.hudsonoaktax.com on February 22, 2019. Hudson Oak Tax Advisory LLC is a legally separate tax firm from Hudson Oak Wealth Advisory. Other statements and information represented by Hudson Oak Tax Advisory do not necessary represent the thoughts, views or advice of Hudson Oak Wealth Advisory. This post is not an endorsement of Hudson Oak Tax Advisory LLC nor are any posts on www.hudsonoaktax.com an endorsement of Hudson Oak Wealth Advisory.