Are you looking for ways to decrease your tax liability? Investing in an opportunity zone may be right for you. It’s a great way to defer federal capital gains taxes while impacting a low-income community by fueling economic development.
Use this article to help you understand opportunity zones, how the program works, and the tax benefits it offers. Then, talk with your financial advisor to see if it’s your best investment vehicle.
The Qualified Opportunity Zone Program
- The Qualified Opportunity Zone program was established by the 2017 Tax Cuts and Jobs Act to incentivize private, long-term investment in economically distressed communities.
- The program offers potential tax benefits, including deferral, discount, and exemption from federal capital gains taxes.
- Tax benefits are only available when the investment is retained for the timeframe stated in the Qualified Opportunity Fund, usually at least five years.
- Familiarize yourself with the terms outlined in this article and talk to your financial advisor to see if investing in an opportunity zone is right for you.
What is a qualified opportunity zone?
The Internal Revenue Service (IRS) defines a qualified opportunity zone (QOZ) as “an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” In short, it’s a program that encourages new investments in low-income communities by offering tax incentives to taxpayers. Hopefully, this program will spur revitalization, economic growth, and job creation in low-income communities.
And here’s why.
Roughly 12% of U.S. census tracts are Opportunity Zones. These communities were nominated by their state governments and certified by the U.S. Department of the Treasury as qualifying for the program. There are roughly 8,700 certified Opportunity Zones in all 50 states, Washington, D.C., and some U.S. territories. You can view them on the U.S. Department of Housing and Urban Development’s interactive map.
How the program works
In 2017, Congress passed the Tax Cuts and Jobs Act which includes a federal incentive to spur investment in economically distressed communities, Opportunity Zones. The program offers several potential tax benefits for investors who roll over gains earned outside an opportunity zone into one of these communities.
The program’s tax breaks include the following:
- Deferring payment of federal capital gains tax earned outside the zone if the gains are invested in an opportunity fund.
- Reduction of 15% in federal capital gains taxes if the investment is held for at least seven years.
- Exemption from federal capital gains taxes if the investment is held for at least ten years.
Opportunity zone tax benefits are available for most opportunity fund investments, including real estate.
What is a qualified opportunity fund?
The IRS defines a qualified opportunity fund (QOF) as “an investment vehicle that files either a partnership or corporate federal income tax return, is organized to invest in qualified opportunity zone property, and elects to self-certify as a qualified opportunity fund.” At least 90% of the fund’s assets must be in Qualified Opportunity Zone Property.
In other words, a QOF is a legal entity created to invest in Opportunity Zones. These investments can include stocks, partnership interest, or business property.
Qualified opportunity funds are an investment option for taxpayers who wish to take advantage of the program’s tax incentives while helping fund economic and community development in low-income census tracks.
What is a qualified opportunity zone property?
The IRS defines a qualified opportunity zone property (QOZP) as “a QOF’s qualifying ownership interest in a corporation or partnership that operates a QOZ business in a QOZ or certain tangible property of the QOF that is used in a business in the QOZ.”
In short, QOZP refers to any QOZ stock, QOZ partnership interest, and QOZ business property owned by the QOF. It’s different from qualified opportunity zone business property.
What is qualified opportunity zone business property?
A qualified opportunity zone business property is a property located within a QOZ and must be used in a trade or business operated in the QOZ. However, it doesn’t have to be used in a QOZ business.
For example, let’s say you’re a partner in a qualified opportunity fund that recently invested in and revitalized a business office in an opportunity zone in Florida. LinkedIn is interested in renting your space. The QOF can lease the office to LinkedIn, even though they are headquartered in California.
What is a qualified opportunity zone business?
A qualified opportunity zone business (QOZB) is a business that demonstrates that all its tangible business property is located within an opportunity zone. QOZB status helps companies to qualify for opportunity fund financing.
For example, let’s say you own a deli in an opportunity zone. You can apply for QOZB status to help secure financing for your business.
The qualified opportunity zone business designation is designed to help businesses in economically distressed communities secure private investments that aren’t available to other companies.
Who is eligible to create a QOF?
Qualified opportunity fund eligibility is straightforward. Any individual taxpayer or entity can create an opportunity fund. They complete a self-certification process submitted with the taxpayer’s federal income tax return for that tax year.
The benefits and risks of QOFs
Like any investment vehicle, there are benefits and risks to investing in an opportunity zone through a qualified opportunity fund. Let’s take a closer look at some of them.
3 benefits of QOFs
- You have the potential for deferred gain on federal capital gains taxes as outlined above.
- There are no investment minimums or maximums to qualify.
- You can help drive community development with your investment.
3 risks of QOFs
- There’s no guarantee that your investment will yield a profit.
- You must hold on to the investment for the long term to realize the maximum tax incentives.
- Gifting the QOF to a nonprofit or charity other than the taxpayer’s spouse is considered an inclusion event and may result in them having to pay the deferred gains.
Are there any alternatives to a QOF?
Yes. Taxpayers looking for ways to defer federal capital gains tax could consider a 1031 exchange. A 1031 is also known as the like-kind or Starker exchange. It’s a tax break that allows a taxpayer to sell a business property or real estate held as an investment and use the profits to invest in a new property while deferring the capital gains tax on the sale.
Is a QOF right for you?
As with all investment strategies, it depends on your financial goals and situation. Talk to your financial advisor about opportunity zone investment. They’ll help you determine if investing in an opportunity zone through a qualified opportunity fund is right for you.
The bottom line
Opportunity Zones were created as part of the 2017 Tax Cuts and Jobs Act to spur new investment in economically distressed communities. The program allows individual taxpayers and real estate investors to defer capital gains taxes if they invest gains into an opportunity fund. Opportunity funds are an investment vehicle that offers a lot of great tax incentives for people who also want to make an impact in low-income communities. However, they are a long-term investment strategy that may only be right for some.
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