Over the past two years, I’ve had numerous colleagues, clients, and investors approach me with questions about Qualified Opportunity Zones. As they are a relatively new financial investment vehicle, most people are unaware of what they are, how they are changing the world of real estate investing, and how they can benefit from the unique tax advantages offered by OZs.
Congress created these new tax-advantaged investments with the passage of the 2017 Tax Cuts and Jobs Act (TCJA). This bill has had dramatic effects on the overall financial landscape and the real estate sector in particular. A subsection of the bill, the “Investing in Opportunity Act” fostered the creation of “Opportunity Zones” and “Opportunity Zone Funds.”
In creating this legislation, Congress aimed to leverage private sector capital to spur real estate and financial development in areas that are economically disadvantaged, including regions in Dallas, Dallas County, and throughout the state of Texas. The bill encourages investment in these areas by offering substantial tax breaks for investing in a “Qualified Opportunity Zone Fund.”
Opportunity Zones are federally designated census tracts, which are primarily comprised of economically depressed areas, as defined by the TCJA. Deploying capital in these areas affords tax benefits to investors, which are intended to spur development in otherwise underserved regions. State governors initially designate which neighborhoods become Opportunity Zones, and the US Treasury gives final approval. Up to twenty-five percent of low-income areas, and five percent of other regions from each state are eligible to enter the program.
You may think that your motivation for investing in Opportunity Zones is to receive capital gains tax incentives exclusive to the OZ program, and there is some truth to that. However, through my experience, I’ve found that investors should focus on the real estate opportunity at hand first, and programs and incentives second. Government initiatives like Opportunity Zones can improve the fortunes of a lagging neighborhood, but forward progress is by no means guaranteed. Put another way- an investment usually doesn’t become a home run just because of tax relief benefits. As with any investment you make, do your research or invest through a trustworthy and knowledgeable asset manager.
Opportunity Zones were created to encourage economic growth in the designated regions. To ensure this happens there are limitations on the types of assets in which the managers of an Opportunity Zone Fund can invest. In order to benefit from the program, investors must either form a partnership with business interests in an OZ, or own equity in a business based in an Opportunity Zone.
The types of real estate investments that are allowed under OZ regulations are limited to ensure that the communities are improved with each investment. For the most part, Opportunity Funds are only able to invest in constructing new buildings, or substantially improving current residential and commercial structures. If Opportunity Funds invest in building improvements, the total rehabilitation capital outlay must be more than the initial purchase price of the building. In addition, any development projects- new construction or rehab- must be completed within a 30 month period of the initial purchase.
As I mentioned earlier, as long as companies abide by Opportunity Fund regulations, they are eligible for significant capital gain tax incentives, both immediately upon depositing capital in a project and over the life of their investment. When investors divest their appreciated assets, like stocks or mutual funds, they realize a capital gain. This is a taxable event, and depending on the asset and your tax bracket, you will owe something to Uncle Sam.
With an Opportunity Zone investment, if you reinvest a qualifying capital gain back into an Opportunity Fund, you can reduce and defer your tax liability on said gain. Furthermore, you are also eligible to receive tax-free treatment for all appreciation you earn in the future. Combined, these qualities have the potential to increase after-tax returns for OZ Fund investors dramatically.
As an OZ investor, you have the ability to reinvest your realized capital gains back into a Qualified OZ Fund as well as defer capital gains tax for those earnings until 2027, as long as your investments were held through the end of December 2026. To ensure that you receive preferable tax treatment, it is imperative that you invest in a QOZ fund within 180 days.
The length of your holding period determines how much tax relief you are eligible for. If you hold it for a five year period before the end of December 26, you can reduce your liability on deferred capital gain principal by ten percent- hold it for seven years and you can reduce it by fifteen percent, and if you hold it for ten years or more you will be eligible for permanent exclusion from capital gains taxes, which means you won’t have to pay any capital gains taxes on appreciation.
There are timelines that investors need to follow in order to take full advantage of the tax benefits offered by Opportunity Zones. If you choose to invest in 2019, you will see a number of important milestones appear starting in 2024, all the way through 2029.
Opportunity Zones have a lot to offer to investors as well as underprivileged communities. This unique market-based approach to spur low-income development has already had substantial positive impacts on development levels and property values in many of the Opportunity Zones across the country, from NYC to Portland to Dallas. As long as you plan to hold the investment for at least five years, you have the ability to delay or completely avoid capital gains taxes, provided you follow the rules and regulations set forth in the legislation that created Opportunity Zones and Opportunity Zone Funds.
It is also important to remember that by incentivizing investment in these areas, the government may be playing a significant role in increasing property values in the area, which helps boost your appreciation, and in turn, your ROI.
Ari Rastegar is the founder and CEO of Rastegar Property Co., an Austin-based real estate investment firm.