Tax Benefits Opportunity Zone Funds: The Investor's Guide

Written By
Carl E. Sera, CMT
Published On
July 5, 2023

Opportunity Zone Funds offer tax benefits to investors who put their capital gains into eligible, low-income areas. Learn all about the tax benefits of Opportunity Zone Funds in this informative guide.

Qualified Opportunity Zone Fund DevelopmentThe 2017 Tax Cuts and Jobs Act brought significant changes to the federal tax landscape. The development of the Qualified Opportunity Zone (QOZ) program, which provides taxpayers with a potential federal capital gains tax advantage for committing to long-term investments in economically distressed areas, was one of the modifications.

Specifically, by investing in a Qualified Opportunity Fund (QOF) established under this scheme, taxpayers may be able to delay and potentially reduce reported capital gains. The program's goal is to stimulate economic development and employment creation in economically challenged areas.

Keep reading to learn more about the tax benefits associated with investing in an Opportunity Zone Fund, even as a first-time investor.

What is an Opportunity Zone?

An Opportunity Zone is a community nominated by the state and certified by the Treasury Department as qualifying for this program. The Treasury Department has certified zones in all 50 states; Washington, D.C.; and U.S. territories. A list can be found at the U.S. Department of Housing and Urban Development (HUD).

What is a Qualified Opportunity Fund (QOF)?

A QOF is a domestic corporation or domestic partnership that invests in real estate within a QOZ. A QOF can invest directly in QOZs by owning business property there, or indirectly by owning stock or an ownership interest in specific enterprises there.

A Qualified Opportunity Fund investment, like any other, may gain or lose value over time. Furthermore, income may be paid on this investment. Given that the program's goal is to enhance specific locations, the fund is expected to continue investing in the rehabilitation of the property in which it is invested. Cash flow may occur once the property improvements are complete and the property is leased or sold to third parties.

The Potential Tax Benefits Of QOFs

There are three possible income tax incentives for taxpayers interested in investing in a QOF: deferral, discount, and exemption.

Tax deferral through 2026

A taxpayer may elect to delay the tax on some or all of a capital gain if they invest in a Qualified Opportunity Fund during the 180-day period beginning on the date of sale/exchange. Any taxable gain in a Qualified Opportunity Fund is not recognized until December 31, 2026 (due with the filing of the 2026 return in 2027), or until the fund's interest is sold or exchanged, whichever comes first.

For example: Nancy liquidates her portfolio in April 2020 and generates a $5 million long-term capital gain. She invests only the $5 million capital gain into a QOF in December 2020 (Notice 2020-39 extension). By investing in a QOF within 180 days, Nancy may defer $1.19 million of capital gains tax ($5 million x 23.8%) that would have been payable on her 2020 income tax return.

No tax on 10% or up to 15% of deferred gains

A taxpayer who defers gains by investing in a Qualified Opportunity Fund obtains a 10% tax basis step-up after five years and an additional 5% step-up after seven years. Thus, in order to qualify for the 10% step-up in tax basis, the taxpayer had to invest by December 31, 2021, and invest by December 31, 2019 to qualify for the extra 5% step-up in tax basis. If the taxpayer has held the investment in the fund for seven years by the end of 2026, the taxpayer is eligible for the 15% tax base increase.

For example: At the time of the initial investment in December of 2020, Nancy’s cost basis in the QOF is considered to be zero, even though she contributed $5 million. In 2025, Nancy’s cost basis in the QOF should increase from zero to $500,000 (which is a 10% increase, calculated based on the original $5 million contribution amount) because she would have held the QOF for 5 years.

In 2026, Nancy may then recognize only $4.5 million in capital gains instead of the $5 million that she would have recognized in 2020 had she not invested in the QOF; thus saving approximately 10%, or $119,000, in capital gains taxes. As of the time of this writing, this additional 10/15% step-up is no longer applicable.

No tax on the appreciation

Finally, a taxpayer may be able to permanently exclude any appreciation on the original capital gains investment in the QOF if the funds remain in the QOF for at least 10 years.

For example: By 2030, Nancy’s interest in the QOF has increased from $5 million to $10 million. Nancy decides to exit the QOF and liquidates her entire position. Nancy already reported her capital gains on her initial $5 million QOF investment on the mandatory recognition date of December 31, 2026 and paid the related tax by April 15, 2027, using assets outside the QOF. The remaining $5 million should not be subject to capital gains tax since Nancy was invested in the QOF for at least 10 years.

Final Thoughts

Investing in a QOF may provide economically distressed communities with potentially significant funds and job growth, while at the same time providing investors/taxpayers with tax incentives to participate in the program. But caution should be taken when evaluating available QOFs to determine if the fund is a suitable option when seeking tax incentives, or if an alternative, such as a 1031 exchange, may be a better option.

Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.” 

If you want to explore your options, make a no-obligation appointment with us today.

Discover the possibilities.    

Carl E. Sera, CMT

Carl E. Sera, CMT

Managing Principal, Sera Capital
Carl Sera is a Chartered Market Technician and the Managing Principal at Sera Capital Management, LLC. He has over 16 years of experience in the financial services industry with a focus on investment management.

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