If you’re reading this article then you’re probably slightly intrigued about the tax incentives behind investing in Qualified Opportunity Zones (QOZ):
- Tax deferral of capital gains until December 31, 2026,
- partial exclusion of 10% of the original capital gain if the investment in a QOZ is held for five years and an additional 5% if held for two more years (total of 15% exclusion if held for seven years) and
- exclusion of all capital gains from the appreciation of your investment in a QOZ if the investment is held for ten years.
In my first article in this three part series (What are the Qualified Opportunity Zone Tax Incentives?) I discussed everything you need to know about investing in Qualified Opportunity Zones in 2019.
- What is a qualified opportunity zone?
- What are the tax incentives?
- How do I invest in one of these zones?
- What taxpayers are eligible to invest in these zones?
- What are the requirements to get the full tax benefits?
The first article was meant to be a detailed breakdown of the QOZ tax incentives and all the carrots and sticks hidden inside the new tax provision. But now it’s time for the fun part – who can actually benefit from these tax incentives?
Now that we know about the new provisions in the law (or at least enough to be dangerous) we can be tactical. This article will breakdown different scenarios where investing in a QOZ can be extremely lucrative.
Real Estate Investors Already Investing in Low Income Communities
The most obvious taxpayer that would benefit from investing in a QOZ would be taxpayers who already invest in a QOZ. These are the people who were investing in QOZs before they were even called QOZs.
If you’re a real estate investor who holds property in a QOZ (you can see if you are by checking out this cool interactive map) then you already know the risk and rewards of investing in low income communities. Congress just tossed you a free bone if you’re willing to add to your real estate holdings.
There are several tax breaks and incentives at the federal, state and local level that make it more worthwhile for real estate investors who own low income housing and this new provision in the tax law only sweetens the deal.
Specifically, those considering a 1031 exchange might want to consider a QOZ. In a 1031 exchange you can’t take cash off the table without paying tax and you aren’t eliminating the gain you are just rolling the gain into the new property. By selling the property and reinvesting the gain into a QOZ you can defer the gain, exclude a portion of that gain and effectively stop any additional gains from building up in the new investment.
One of the most lucrative possibilities under the new QOZ rules is the potential tax free sale of a startup in a QOZ. Think about selling your startup for millions and walking away paying no tax at all.
If you read my last article then you know you can’t play the QOZ game unless you’re sitting on an unrealized capital gain. These rules were primarily written for investors who are holding onto multimillion dollar unrealized capital gains who are willing to take the risk and invest those funds into a QOZ.
If you’re thinking of launching a startup then odds are you don’t have millions of dollars sitting in stocks and bonds. But to play the game you just need any capital gain. Assuming you have $100 in unrealized Bitcoin gains you could potentially realize those gains and invest that $100 in 100 shares of your new company.
You might not have millions of dollars but you have thousands of hours of sweat equity. If you can turn that $100 into a multimillion dollar company (located in an opportunity zone and primarily doing business within an opportunity zone) then you could sell you interest after ten years and walk away with millions in tax savings.
One of the biggest hesitations for investors has been the uncertainty of investing in QOZs. For most investors, they know little about these neighborhoods and don’t know if there is potential for future income or appreciation.
On top of these risks and uncertainties exist an added hesitation because the rules lock in these investments for a decade. As an investor you can pullout your funds before the ten year mark but you’ll lose all of the tax incentives.
Even if you’re willing to hold the investment for ten years you can’t control the actions of those inWashington. President Oprah (or whoever is elected president in 2020) could easily reverse all the QOZ rules.
For these reasons many high net worth individuals and those active in private equity are extremely hesitant to take the plunge. However, the rules as they are written now make it extremely easy for private equity to at least dabble in these funds.
As discussed in my previous article, in order to invest in a QOZ you need to invest through a Qualified Opportunity Fund (QOF). As long as this fund invest 90% of its assets in QOZ property then it can benefit from the tax incentives.
QOZ property can be a direct investment in a piece of real estate or it could be an indirect investment in partnership interest or C Corporation stock of QOZ businesses that hold 70% of its assets in QOZ property. Effectively, a QOF fund can be structured to hold as little as 63% of its assets in QOZ property.
This is where the QOZ rules get interesting. Those in private equity could diversify QOF assets and effectively securitize investments in QOZs. This proposition makes investing in QOZs interesting because those who already invest in real estate property within a QOZ and those willing to expand business activity or form a new business in a QOZ could partner up with private equity to mutually benefit from these tax savings.
Essentially, investing in a QOF can be as easy as moving funds from one brokerage account to another.
In this article I discussed all the potential benefits of investing in a QOZ and only lightly touched upon the potential unintended consequences of investing in a QOZ – this is where the third installment of this series comes into play.
There are several rules that haven’t been finalized and many questions that have been unanswered. Until we have final regulations and have concreate answers to specific facts and circumstances regarding investing in these QOZs I would caution any investor to reconsider jumping in too quickly.
In my third and final installment (assuming you’ve made it this far) I will cover all those unanswered questions and the potential pitfalls of investing in a QOF.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.