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This is Chapter 4 of The Ultimate Guide to Opportunity Zone Investing
Updated October 29, 2020
Qualified Opportunity Funds (QOFs) were created under the Investing in Opportunity Act, a version of which was passed as part of President Trump’s Tax Cuts & Jobs Act of 2017. Per the IRS, QOFs self-certify using IRS Form 8996, with no approval process required. These new funds provide massive tax incentives for investing capital gains in some of America’s most economically distressed communities.
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Qualified Opportunity Funds defined
The U.S. tax code defines a Qualified Opportunity Fund as an investment vehicle that invests in Qualified Opportunity Zone Property. Specifically as follows:
The term “qualified opportunity fund” means any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund) that holds at least 90 percent of its assets in qualified opportunity zone property, determined by the average of the percentage of qualified opportunity zone property held in the fund as measured—(A) on the last day of the first 6-month period of the taxable year of the fund, and (B) on the last day of the taxable year of the fund.
Opportunity Zone property can be either an Opportunity Zone business or Opportunity Zone business property. Put another way, a Qualified Opportunity Fund has two options:
- It can invest in Opportunity Zone businesses that hold tangible property located within Opportunity Zones.
- It can essentially become an Opportunity Zone business by investing directly in tangible property located within Opportunity Zones.
In practice, most Qualified Opportunity Funds opt for the first option, structuring such that the fund holds an underlying QOZB (or multiple QOZBs). The QOZB then holds the QOZBP property.
Let’s now define these two terms — Qualified Opportunity Zone Business (QOZB) and Qualified Opportunity Zone Business Property (QOZBP).
Qualified Opportunity Zone Business (QOZB)
An Opportunity Zone business can be either a corporation or partnership. In general, a QOZB is a trade or business in which substantially all of the tangible property of the business qualifies as follows:
- Such property was acquired by the business by purchase after December 31, 2017.
- The original use of such property in the Opportunity Zone commences with the QOZB, or the QOZB substantially improves the property.
- During substantially all of the QOZB’s holding period for such property, substantially all of the use of such property was in a Qualified Opportunity Zone.
Furthermore, the QOZB must also adhere to the following criteria:
- At least 50 percent of the total gross income of the QOZB is derived from the active conduct of such business.
- A substantial portion of the intangible property of the QOZB is used in the active conduct of such business.
- Less than 5 percent of the average of the aggregate unadjusted bases of the property of a QOZB is attributable to nonqualified financial property.
And finally, the following types of “sin” businesses are ineligible to be deemed as a Qualified Opportunity Zone Business — private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or liquor stores.
Qualified Opportunity Zone Business Property (QOZBP)
QOZBP is tangible property used in a trade or business of a Qualified Opportunity Fund, so long as it meets the following three conditions:
- Such property was acquired by the Qualified Opportunity Fund by purchase after December 31, 2017.
- The original use of such property in the Opportunity Zone commences with the Qualified Opportunity Fund, or the fund substantially improves the property.
- During substantially all of the Qualified Opportunity Fund’s holding period for such property, substantially all of the use of such property was in an Opportunity Zone.
Tax advantages of Opportunity Zone investing
To encourage capital deployment to economically distressed Opportunity Zones, three tax advantages were created for capital gains invested in Qualified Opportunity Funds.
- Deferment of capital gains until December 31, 2026.
- Reduction of capital gains recognition of up to 10 percent on the original gain.
- Elimination of capital gains accrued in the opportunity fund after a 10-year holding period.
Advantage #1: Deferral of capital gain recognition until December 31, 2026
Any capital gains rolled into a Qualified Opportunity Fund within 180 days will be tax deferred until December 31, 2026, or the date on which the Qualified Opportunity Fund investment is sold, whichever is earlier.
Advantage #2: Reduction of capital gains recognition
Investments into a Qualified Opportunity Fund are eligible for a 10 percent basis step-up after a 5-year holding period, so long as this milestone is reached by December 31, 2026 (the date on which the original capital gain must be recognized).
Note: There was a 15 percent basis step-up available for 7-year holds that expired after December 31, 2019. And the 10 percent basis step-up upon reaching a 5-year hold will expire after December 31, 2021.
If by December 31, 2026 the investor has held his Qualified Opportunity Fund for at least 5 years, the amount of capital gain recognition on his original investment is effectively reduced by 10 percent, per Section 1400Z-2(b)(2)(A).
The reduced capital gains tax payment would come due in April 2027. Of note is the fact that the 2026 tax rate would be applied. Tax rate risk is an issue to consider. Of course, if taxes on capital gains do increase between now and 2026, it would make the third advantage of Opportunity Zone investing just that much more powerful!
Advantage #3: No tax owed on capital gains from Qualified Opportunity Fund investments
This is by far the biggest benefit of the Opportunity Zones initiative, and the #1 reason why Treasury Secretary Steven Mnuchin expects more than $100 billion in investments to flow to Opportunity Zones as a result of the policy.
So long as a Qualified Opportunity Fund investment is held for at least 10 years, the basis of the investment will be adjusted to be equal to the fair market value of the investment on the date on which it is sold. In other words, there is zero capital gains tax due on any profits from the sale of an Opportunity Zone investment after a 10-year holding period.
Opportunity Zone fund vs. Section 1031 exchange
Savvy investors are familiar with 1031 exchanges. And Opportunity Zones appear similar at first glance. But there are a few substantial differences, summarized below.
In a Section 1031 exchange, an investor must reinvest both the principal and capital gain within 180 days. And this transaction must be conducted through a qualified intermediary.
With an Opportunity Zone investment, an investor is only responsible for rolling over the capital gains within 180 days. The investor is not required to deploy the entire gain, but only the rolled over portion is eligible for tax advantages. Moreover, the principal can be used for anything. It does not need to be rolled over. And, placing an investment in a Qualified Opportunity Fund is much more straightforward, with no intermediary required.
Only real estate gains are eligible for 1031 like-kind exchanges. Conversely, capital gains from any type of asset sale (real estate, stocks, bonds, etc.) can qualify for investment in a Qualified Opportunity Fund. Section 1231 gain is also eligible for investment in Qualified Opportunity Funds.
A Section 1031 exchange is structured to allow for single asset swaps, usually one real estate property for another real estate property. Multiple properties can be supported, but this option usually comes with higher costs and less flexibility.
On the other hand, Qualified Opportunity Funds can be either single-asset funds that invest in a single property or business, or multi-asset funds that invest in multiple properties across asset classes and geographies.
Capital gains tax deferral
Capital gains tax payments on a 1031 exchange can be deferred indefinitely. With Qualified Opportunity Funds, capital gains of the initial investment may be deferred until December 31, 2026.
Capital gains tax reduction
With 1031 exchanges, capital gains are reduced through a step-up in basis only upon death. With Qualified Opportunity Funds, the investor receives basis step-ups of 10 percent after 5 years and an additional 5 percent after 7 years, to account for a total available capital gains tax reduction of 15 percent. Note: the ability to achieve a 15 percent basis step-up expired after December 31, 2019.
Capital gains tax on final sale
With a 1031 exchange, the investor owes capital gains tax on final sale of the asset.
This may be the best benefit of investment in a Qualified Opportunity Fund: zero capital gains tax is due on any appreciation of the Qualified Opportunity Fund investment upon disposition, so long as the investment is held for at least 10 years.
Location, location, location
With a 1031 exchange, the investor’s real estate can be located anywhere in the country.
Conversely, Qualified Opportunity Fund investments are limited largely to Qualified Opportunity Zone Property located in Opportunity Zones, the vast majority of which are low-income.
How to invest in Qualified Opportunity Funds
Visit our list of Qualified Opportunity Funds to start screening the different Opportunity Zone investments that may be available to you. Note: most Qualified Opportunity Funds are only permitted to accept investment from accredited investors. Many have minimums of at least $25,000.
You can also form your own Qualified Opportunity Fund (more information below).
Or, contact your financial advisor for additional information.
Forming a Qualified Opportunity Fund
Any entity that is taxed as a corporation or partnership can self-certify as a Qualified Opportunity Fund by completing IRS Form 8996. That part is easy.
Creating the organizing documents, compliance process, and audit trail can be challenging. Visit OZ Pros to learn more about how to create an Opportunity Zone fund.
Disclosure: The author of this guide has ownership in OZ Pros.