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Exploring the Benefits of Opportunity Zone Funds
As an exit planning firm, Sera Capital gets daily inquiries about 1031 exchanges from all over the United States. In most cases, the appropriate solution is a 1031 exchange. However, sometimes it’s not in our client’s best interest. We quickly point out an alternative, perhaps a better solution, such as investing in a Qualified Opportunity Zone Fund or QOZ.
A QOZ is a public/private partnership where the government incentivizes investors to sell appreciated assets, which they would typically not sell, and then divide the sale proceeds into two pieces. One piece is the asset’s original investment or cost basis, and the other is the capital gain on the asset sold. The government lets the investor immediately keep their cost basis and invest it however they choose. They then ask the individual investor to invest the capital gain in projects in opportunity zone geographies that benefit economically distressed areas and society. In exchange for helping society, the government provides the investor with substantial tax savings if they follow specific criteria, thus earning the investor an attractive rate of return. The goal is a Win/Win, which has worked quite well so far. We believe this will continue for quite some time.
QOZs can be utilized as a tax savings and attractive rate of return vehicle from the sale of any asset, which includes stocks, real estate, jewelry, art, collections, crypto, etc. If there is a capital gain, the capital gain can be invested in a QOZ. As an example, if you purchased stock in Apple for $4 and sold it for $10 then you can put the $4 back in your pocket and pay zero taxes on it and invest the $6 in a QOZ and receive substantial tax savings and attractive returns on the $6 investment. The same applies to any asset with capital gains, including real estate. In most cases, we’ve seen that most real estate investors choose a 1031 exchange instead of the QOZ.
Let’s look at the cases where investors invest in a QOZ instead of utilizing a 1031 exchange. Before we do, let’s set the stage once again using the $4 cost basis and the $6 capital gain. Why would an investor not want to do a 1031 exchange instead of investing in a QOZ? There are many reasons, and we will explain the main ones later. Still, before we do, it’s essential to understand that with a 1031 exchange, the entire $10 must be invested to fully benefit from the tax savings. With the QOZ, you only need to invest $6. Thus, the real estate investor can take that $4, and if they choose to diversify away from real estate, they can. In contrast, the 1031 investor is forever tied to real estate. Furthermore, once the QOZ matures or refinances, the proceeds no longer need to be invested in real estate if the investor chooses that route.
Because of the unique properties of a QOZ, we like to refer to a QOZ as a “shapeshifter” or “portfolio shifter” because it allows the investor that is overweight in real estate to move into asset classes other than real estate. It will enable the underweight real estate investor to move into real estate, which is all done tax efficiently with a Win/Win intention.
We won’t explain all the nuances of a QOZ because they can get somewhat thorny but suffice it to say, they should be considered, and at a minimum, they should be understood as an alternative to a 1031 exchange. In our practice, we find that about 10% of people who call us looking to execute a 1031 exchange to invest the proceeds into a Delaware Statutory Trust (DST) buy a QOZ instead once they understand the advantages.
We know what you are thinking. You probably believe Sera Capital has a financial incentive to recommend a QOZ instead of a DST. We don’t. We have a disincentive.
If you’ve been paying attention, you will notice that if you invest in a DST through the 1031 mechanism, you must invest the entire $10, while with the QOZ, you only need to invest $6. Sera Capital’s fees are higher if you invest $10 than $6, so when we recommend a QOZ over a DST, you can rest assured that we think it is in your best interest.
One last important point to make when differentiating between QOZs and DSTs. DSTs are inherently more conservative assets than QOZs. DSTs are typically single asset fully leased properties that require very little or no capital expenditures. They are considered to have no construction or development risk. Conversely, a QOZ requires the sponsor to develop or renovate at a significant cost. There is little doubt that a QOZ thus has more risk associated with it than a DST. The QOZs we recommend certainly do; therefore, they offer the potential for higher rates of return than the typical DST.
We know several of our clients buy QOZs when they sell highly appreciated stocks because they want to own real estate and garner tax savings. We also know that investors that are overweight in real estate enjoy the benefits of a QOZ to diversify their portfolio. But who buys QOZs when they sell real estate? Please note that real estate investors that purchase either DSTs or QOZ do so because they no longer want to be active investors. They no longer wish to own real property and have mentally switched from active to passive real estate investing. Once you’re comfortable with a passive approach to real estate investing, these are the profiles of people we think should take a closer look at QOZs for their tax planning considerations.
What types of investors choose to invest in Qualified Opportunity Zone Programs?
- Investors that look at returns from conservative DSTs and sneer. They want higher rates of return, and they recognize that the DST design is not aggressive.
- Investors that want to invest in the common good and yet want an attractive rate of return.
- Younger investors that have acquired real estate but realize quickly that being a landlord is not their cup of tea but are too young, in our opinion, to purchase the best type of DST, which is the DST that converts to a
- They have a high-cost basis and want to avoid paying taxes even on the little bit of capital gains they would make on selling their property.
- They are selling a business. In this case, business sales are divided into three parts. Part 1 is real estate, part 2 is goodwill, and part 3 is personal property. They then 1031 exchange the real estate portion into DSTs, then take a portion, if not all, of the capital gains associated with the goodwill and personal property and invest in QOZs.
- People that are selling highly appreciated stocks.
Let’s look at investor number 1 above because they are usually quite sophisticated real estate investors. They want higher returns but also want income. Since QOZs typically don’t pay any income in the first few years because they are either developing a project or adding significant value, the investor can only expect to earn interest from their investment once the project starts generating income in a few years. But they can set aside the original cost basis as an income substitute until the QOZ generates income. This is a widespread practice.
Let’s look at investors number 5 and 6 above because they have many people chirping in their ears telling them what to do with the sales proceeds from their business or stock sale. Let’s also remember that with a 1031 exchange, if appropriately structured, most investors can eliminate taxes on the sale of real estate. However, as we stand today, the investor selling a business or highly appreciated stock has only one solution that can eliminate the tax: an investment in a QOZ, and only some QOZs have this capability. Any other solution we’ve encountered, which typically falls under section 453 of the IRS code, defers taxes but does not eliminate them.
In closing, when exiting a highly appreciated investment, you can defer or eliminate taxes depending on the type of asset held and how you reinvest the proceeds. Details matter: the more you know, the more comfortable you will be with your decision.
If you’d like to know more about Qualified Opportunity Zone Funds, Schedule Your Free 30 Minute Call with Sera Capital Today.