Qualified Opportunity Zone Fund

The federal government’s Tax Cuts and Jobs Act of 2017 established Qualified Opportunity Zone provisions to stimulate economic development. It’s important to understand that there was near unanimous consent for this in Congress.  These provisions provide potentially significant tax benefits to investors who re-invest capital gains into long-term investments in QOZs. While the tax benefit of investing in or creating a qualified opportunity fund (QOF) may be appealing, there's a lot to know about this medium of investing because like most new tax legislation, it’s complicated.

What Are Opportunity Zones?

Opportunity Zones are areas that have seen significant economic distress. Certain new investments in these communities qualify for a number of tax benefits. Created as part of the 2017 Tax Cuts and Jobs Act (TCJA), Qualified Opportunity Zones (QOZ) are meant to spur investment in areas that have struggled economically by setting up special tax treatment for investors in these areas.

As of this writing, there are 8,764 Opportunity Zones within the U.S. The areas run the gamut from urban to suburban to rural in terms of population size. To see which areas are eligible for incentives under the program, check out HUD’s QOZ map.

What Is A Qualified Opportunity Fund?

A qualified opportunity fund is an investment vehicle, such as a corporation or partnership or REIT, that has elected to annually file Form 8996 with the IRS while investing 90% or more of their assets in one or more qualified opportunity zones. This annual designation allows the fund, which means you as the investor, to gain preferential tax treatment for investments held for five years or more.  However, our firm, Sera Capital feels strongly that to take full advantage of the legislation, the investor must have at least a 10-year time horizon.  We will not recommend an OZ Fund to our clients unless they believe they can hold it for 10 years.

A qualified opportunity zone fund can invest in any qualifying investment, which includes tangible property, equipment, or businesses in which 50% or more of gross income is earned from activity within the opportunity zone. However, commercial and residential real estate investments are currently the most prevalent opportunity fund investment.

Benefits of Investing in An Opportunity Zone Fund

Investors who have eligible capital gains, which could be from the sale of stocks, real estate, businesses, or other investments earned before Jan. 1, 2027, can roll their qualified gains into a qualified opportunity fund. Investors have 180 days or less from the realized gain to elect their eligible gain by filing Form 8949 as well as Form 8997, which provides them the opportunity to benefit from the following tax incentives:

• Temporary Deferral

Capital Gains from the sale of any asset (if reinvested in 180 days) are deferred until the sale of the new investment, or December 31, 2026, whichever is earlier.

For example, if a taxpayer sells an asset for $6 million, with a cost basis of $1 million this results in a $5 million capital gain.  The investors can invest the proceeds into a Qualified Opportunity Zone Fund and as long as this happens within 180 days of the sale, the investor avoids current capital gains taxation. Furthermore, the legislation allows the investor to keep 100% of their cost basis at the time of the sale which in this case is $1 million.  This is all with zero tax at time zero. This could potentially provide a substantial return for the investor through the life of the investment because it’s what we call “versatile” money.  It can be invested in anything and this is often attractive if the $1 million return of cost basis comes from the liquidation of a single stock, business or parcel of real estate as is often the case.

• Step-Up in Basis

Any investment re-invested and held for 5 years gets a tax basis increase of 10%, and any investment held for 7 years gets a tax basis increase of 15%.  It’s important to understand that temporary deferral and then the Step-Up in basis are nice, but hardly an incentive to invest in an OZ Fund.  We like to say that the benefits of an OZ fund are three-fold.  They are Defer, Reduce and Eliminate.  We value the benfits of each of the 3 at about 5% for Defer, 5% for Reduce and 90% for Eliminate.  So don’t get too caught up in what happens in the first 5 years of the OZ zone fund.  The benefit comes after 10 years.  Nevertheless, lets explore this part of the OZ Fund.

If we use the example above, after five years of investing in the fund, the taxpayer may be given a $500,000 basis. This is 10% of the original $5 million capital gain deferred. If the investment is held in the fund for seven years, the investor may be given another $250,000 of basis in the fund. This is 5% of the original capital gain. Together, this is a total of $750,000, or 15% of the original capital gain.  What this means to the taxpayer is that on April 15, 2027 instead of having to pay the capital gains tax on the entire $5 Million they only have to pay tax on $4,250,000.

Here is where it gets complicated.  The capital gains tax is computed based on the rate in 2026 and not the current rate.  So, if capital gains taxes increase, the amount of tax goes up accordingly.  This may seem like a bad thing, but once you understand the eliminate part of the equation, you can see that it would more than likely be beneficial because upon liquidation, you would then enjoy the benefits of the higher capital gains tax even more.

• Permanent Exclusion

Here’s the reason to invest in an OZ Fund.  Investments held for 10 years will pay no capital gains tax on the post-acquisition gains. This permanent exclusion applies only to the gains accrued in the OZ Fund. Keep in mind, while this can potentially lower the cost basis, it doesn’t eliminate the gain recognized on December 31, 2026.

For example, let’s say a taxpayer makes a $5 million investment in a Qualified Opportunity Zone Fund in 2019. If the investor sells the investment in 2029 for $10 million, the $5 million in appreciation is free of taxation. However, the investor will have to pay income taxes on April 15, 2027 since the fund was held beyond 2026. These taxes will correspond with the sale of the investment.  They were deferred for a number of years, and they were reduced, but the tax is not eliminated.  Only the capital appreciation of the investment is eliminated.  Our advice, pick good OZ Funds if this investment sounds like something that suits you.

How does an Opportunity Zone Investment Compare to a 1031 Exchange?

There are significant differences between the tax benefits that accrue from an investment in an Opportunity Zone versus like-kind property that qualifies for a 1031 exchange.

Among the major differences are that, for a 1031 exchange, only your real estate assets qualify and the exchange must include the value of the asset and the gain. For an Opportunity Zone investment, all assets that give rise to a capital gain qualify and only the gain portion of the transaction must be reinvested.

The time horizon is another difference. For a 1031 exchange, the step-up in basis only occurs upon death. For an Opportunity Zone investment, the increase in basis occurs once the investment is held for more than 10 years.

Also, mechanically, the 1031 requires a Qualified Intermediary and the OZ Zone fund does not.  The investor can take receipt upon sale without the services of a QI.

The Bottomline

The federal tax rules for Opportunity Zones are detailed and complex, and cannot be fully explained in this overview. Consult with a tax advisor before making any business or financial decisions based on this tax benefit. If you have additional questions about Opportunity Zones, reach out to us at Sera Capital for help.  We’ve looked at all the top OZ Funds and have settled on just a few that we like.

To learn more about Opportunity Zone Fund investments to defer capital gains tax, schedule your call today.