10 Important Things to Know About Investing in Opportunity Zones

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Opportunity Zones were created to spur job growth and economic development in low-income communities by offering investors an incentive to place capital into underdeveloped markets. While interest has been increasing over the past year, there are 10 important things to know about Opportunity Zones before deciding to invest.

1. Over 8,700 Opportunity Zones to Choose From

There are over 8,760 Qualified Opportunity Zones in all 50 States, the District of Columbia, and five U.S. territories. The 2017 Tax Cuts and Jobs Act (TCJA) created the Opportunity Zone Program, which is intended to stimulate economic development and job creation with long-term investments in low-income neighborhoods.1

2. Three Benefits of Opportunity Zone Investing

Any business or individual with capital gains from the sale of an investment asset can receive tax benefits for investing unrealized capital gains in Opportunity Zones:2

  • Payment of the tax on previously earned capital gains that are reinvested in an Opportunity Zone is deferred until the end of 2026 (or when the asset is sold)
  • Basis of the original investment is increased by 10% if the Opportunity Zone investment is held for at least five years
  • Additional capital gains produced from the Opportunity Zone investment are permanently excluded from capital gains tax, provided the investment is held for at least 10 years

3. Key Opportunity Zone Terms to Understand

There are three key terms to understand about Opportunity Zones:

  • QOZ: Qualified Opportunity Zone is a low-income community census traded designated by each state or territory and approved by the federal government
  • QOF: Qualified Opportunity Fund is a corporation or partnership formed for the express purpose of investing equity into a Qualified Opportunity Zone property
  • QOZP: Qualified Opportunity Zone Property can be real estate or business property, corporate stock, or a partnership interest in an entity the does business primarily in a QOZ

4. Pay Zero Dollars in Capital Gains Tax

For long-term investors, the real bonus in QOZ investing comes after 10 years.3 That’s because after a 10-year holding period, the investment basis is stepped-up to fair market value, which means any appreciation can be sold tax-free.

As an example, consider a $500,000 investment that appreciates in value and is sold after being held for at least 10 years. If the property value increased to $750,000 the entire amount would be a tax-free gain. Of course, as with any other investment, appreciation is never guaranteed due to the specific financial performance of the investment and normal economic cycles.

5. Anyone With a Capital Gain Can Invest in OZs

While real estate investors have long benefited from conducting 1031 exchanges, capital gains from other investments were subject to tax. All of that changed when the TCJA of 2018 was signed into law.

Now, investors with gains from other assets such as stocks and bonds, precious metals, a business, and real estate can choose to invest those capital gains in an Opportunity Zone in order to defer or eliminate some of the gain for tax purposes.4

6. Opportunity Zone Investing Can Be Like a Turbocharged 1031

For real estate investors, investing in an Opportunity Zone has been described by some investors as a 1031 exchange on steroids.5 There are two reasons for this:

  • Unlike a 1031 exchange which requires reinvestment of the sales proceeds, only the capital gains portion from the investment sale needs to be reinvested in a QOF to receive preferential tax treatment
  • Real estate investors have a full 180 days to identify and close on the replacement QOZ investment, versus the more limited 45-day identification period of a 1031 tax deferred exchange

7. OZs May Simplify Investment Portfolio Diversification

In August of this year, The Council of Economic Advisers (CEA) published The Impact of Opportunity Zones: An Initial Assessment.6 The CEA report compares the advantages of OZs to other Federal economic development programs, and documents the characteristics of the over 8,700 low-income communities designated as Opportunity Zones.

For investors, one of the key benefits of placing capital gains in an OZ may be the ability to easily diversify an investment portfolio. That’s because a large percentage of Qualified Opportunity Funds used to invest in OZs have pooled investments across other industries in the OZ, such as health care, technology, and construction in addition to real estate:

  • 45% of QOFs are pooled investment funds across various industries
  • 22% focus on multiple real estate asset classes
  • 18% invest in commercial real estate
  • 9% invest in other assets such as businesses or infrastructure
  • 6% invest in residential real estate

8. Asset Values Increase with Opportunity Zone Designation

The CEA report also learned that census tracts receiving an OZ designation saw a 29% relative increase in equity investment, leading to larger appreciation in housing prices and improved local amenities for renters.

Housing value increases in Opportunity Zones have led to an estimated $11 billion in additional wealth for the nearly half of OZ residents who own their home. Commercial real estate investors have also benefited from Opportunity Zone investments as well:

  • Growth in development site acquisitions increased by 50% year-over-year inside designated OZs, greatly exceeding growth in the rest of the U.S.
  • Prices of redevelopment properties in OZs increased by 14%
  • Prices of vacant development sites in OZs increased by 20%

9. Post-COVID-19 Recovery Boosted by Opportunity Zones

The Impact of Opportunity Zones: An Initial Assessment report from the CEA notes that the available evidence shows that Qualified Opportunity Funds are well positioned to invest in communities in 2020.

In the first quarter of this year, the pandemic triggered a massive selloff in the stock market that very likely generated significant capital gains for investors exiting a long-term bull market. While numerous State-mandated restrictions to slow the spread of COVID-19 have slowed investment everywhere, the CEA believes that capital raised by QOFs grew by about 30% during the first four months of 2020.

The performance of Opportunity Zones before COVID-19 suggests that the OZ model can continue to spur economic recovery post-COVID-19 as well. Capital is mobilized with limited control from the Federal Government, allowing investors to work with local stakeholders to help low-income communities grow and prosper.

10. Not All OZ Investments Offer Equal Opportunity

As with any other type of investment, not all Opportunity Zones provide the same amount of opportunity. Although the opportunity to save on taxes can be very attractive, investors should always be aware that a risky investment could be cloaked inside an OZ investment.7

For example, land and buildings within an Opportunity Zone may have already appreciated to such a degree that there is less potential profit remaining for incoming investors. Also, while some QOFs are diversified across various industries, high costs may offset much of the anticipated tax benefits.

For these reasons and more, potential investments within an OZ should be analyzed based on their own merits and potential performance, and not solely for the tax benefits provided.

Realty Mogul, Co. and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. See offering documents for additional details, disclosures, and disclaimers.

References

1 https://www.eda.gov/opportunity-zones

2 https://www.taxpolicycenter.org/briefing-book/what-are-opportunity-zones-and-how-do-they-work

3 https://www.cpexecutive.com/post/5-things-to-know-about-opportunity-zone-deadlines/

4 https://www.bizjournals.com/nashville/news/2019/06/17/5-things-to-know-about-opportunity-zones.html

5 https://siteselection.com/issues/2018/nov/what-you-need-to-know-about-opportunity-zones.cfm#gsc.tab=0

6 https://www.whitehouse.gov/wp-content/uploads/2020/08/The-Impact-of-Opportunity-Zones-An-Initial-Assessment.pdf

7 https://money.usnews.com/investing/investing-101/slideshows/7-facts-to-know-about-opportunity-zone-investing?slide=7

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