Opportunity Zones – Ultimate Investor’s Guide (2020)September 2, 2020
Thanks to President Donald J. Trump, the Congress passed the law creating opportunity zones (OZs) in 2017. The zones encourage investment in blighted communities across the country. The goal is to boost economic growth and create new jobs in the poorest U.S. neighborhoods through the use of available tax benefits. Let’s discover what are opportunity zones, how they work, and how to invest in opportunity zones, including where are the opportunity zones and what are the opportunity zones tax benefits.
What are Opportunity Zones?
OZs are geographic areas corresponding to low-income census tracts that state governors nominate and the Treasury Secretary certifies. To qualify as an OZ, either of two conditions must apply:
1. The median family income must be below 80% of the surrounding areas, or
2. The average poverty rate is at least 20%
As of now, the OZ program created 8,700 zones in urban and rural areas. Every state and territory has at least one designated OZ. The average poverty rate in these OZs is 29%, depressing real estate markets and the people who live there. In general, OZs had in the decade prior to passage of the enabling legislation suffered with lethargic economic growth and decimated populations.
Underserved communities should benefit from OZ investments, although certainly there are plenty of opportunities for fraud and corruption.
The pre-pandemic makeup of the designated OZ areas includes:
• 1.6 million businesses
• 24 million jobs
• 475 solar energy farms
• 127 wind farms
• 479 airports
• 379 institutions of higher learning
To the extent that capital flows into these opportunity zones marks a chance for improved neighborhoods and enriched investors. Opportunity zone designations will expire on December 31, 2028.
How Do Opportunity Zones Work?
OZs permit investors to invest in businesses operating within its borders and to receive several tax incentives. To reap the tax benefits, the opportunity zone must be qualified. You invest in an OZ through a qualified opportunity fund (QOF).
A QOF is an investment vehicle (corporation or partnership) purposed to invest in the assets within an opportunity zone. You or your entity can create your own opportunity zones via a self-certification procedure.
The first task is to designate which businesses operating within an opportunity zone qualify for inclusion in a QOF. An opportunity zone business (OZB) can qualify if it demonstrates that virtually all of its tangible property resides within a QOZ. Only qualified opportunity zone businesses (QOZBs) and qualified opportunity zone property (QOZP) may participate in a QOF.
Qualified Opportunity Zone Businesses (QOZBs)
For an opportunity zone business to be qualified for inclusion in a QOF, it must earn the majority of its annual gross income form business activities taking place within a QOZ. You can satisfy this QOF 50-Percent of Gross Income Test by meeting any one of the following three safe harbors:
• At least 50% of the total hours of services received by the business occurred in a QOZ, or
• At least 50% of the total amounts that the business paid for services were for services performed in a QOZ, or
• Necessary business functions and necessary tangible property resided in a QOZ.
Qualified Opportunity Zone Property (QOZP)
To quote the IRS:
“QOZ property is 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. To be a qualifying ownership interest in a corporation or partnership, (1) the interest must be acquired after December 31, 2017, solely in exchange for cash; (2) the corporation or partnership must be a QOZ business; and (3) for 90% of the holding period of that interest, the corporation or partnership was a QOZ business.”
You can identify tangible property earning the QOZ business property designation if it meets certain criteria:
• A QOZ business or a QOF trade or business uses the business property.
• You purchase the property no earlier than January 1, 2018.
• The property has to remain in the QOZ.
• The property’s original use started with the QOZ business or the QOF, or the property received substantial improvements by the QOF or QOZ business.
Where are the Opportunity Zones?
The complete list of opportunity zones is available from IRS Notice 2018-48. The following lists summarize the counties in four states that contain opportunity zones.
Opportunity Zones in Florida
The following are opportunity zones in Florida counties containing qualified opportunity zones:
• Indian River
• Palm Beach
• St. Johns
• St. Lucie
• Santa Rosa
Opportunity Zones in California
The following are opportunity zones in Florida counties containing qualified opportunity zones:
• Contra Costa
• Del Norte
• El Dorado
• Los Angeles
• San Benito
• San Bernardino
• San Diego
• San Francisco
• San Joaquin
• San Luis Obispo
• San Mateo
• Santa Barbara
• Santa Clara
Opportunity Zones in Colorado
The following are opportunity zones in Colorado counties containing qualified opportunity zones:
• Clear Creek
• El Paso
• Kit Carson
• La Plata
• Las Animas
• Rio Blanco
• San Juan
• San Miguel
Opportunity Zones in New York
The following are opportunity zones in New York counties containing qualified opportunity zones:
• New York
• St. Lawrence
How to Invest in Opportunity Zones
Here’s how to invest in opportunity zones. The initial question is whether to create your own QOF or invest in an existing one. The latter is much easier. Setting up and running a new QOF is no small feat. You must comply with all the opportunity zone regulations and SEC regulations. Usually, that means creating a private placement memorandum, operating agreements, subscription agreements, and other documents.
If you instead decide to invest in an existing QOF, you’ll need to undertake due diligence on the investments and the management team. You want to make sure that the investment thesis makes sense and that returns have met expectations. Never rush through the decision. It’s not worth entering into a bad deal just to earn some tax breaks. Normally, properties included in a QOF need extensive improvement. Consider properties with excess land for expansion, properties with deferred maintenance, and properties ready for repositioning or new development.
An opportunity zone property’s appeal should hinge on data that you can use to make decisions. This includes all the current metrics plus the growth projections. Focus on the pace of growth, demographics, population, income, business and jobs, rental absorption rates, and property inventory.
Perhaps you feel that an opportunity zone investment is simply about the money you can make. But keep in mind that some of your fellow investors may have additional goals, such as:
• Creating jobs
• Growing household income
• Improving education
• Increasing average wages
• Positively impacting the environment
• Reducing crime
• Reducing inequality
• Reducing unemployment
Closer to home, opportunity zones invite investments because of their tax benefits.
Most QOFs accept only accredited investors. That means you must have a net worth of $1 million (excluding your primary residence) or you’ve had an annual income of $200,000 ($300,000 for joint filers) for two consecutive years. Expect to pay an annual fee around 2% and to cough up 20% of the gains you earn in excess of the promised minimum. That promised minimum return is usually in the 6% to 10% range for diversified QOFs, higher for single property funds.
Certain properties are ineligible for inclusion in a QOF. These include liquor stores, casinos, brothels, massage parlors, opium dens, golf courses, and dungeons. Any property that participates in criminal acts would most assuredly not qualify. Remember that QOF investments are inherently risky. One riot can wipe out your entire portfolio. Also, insist upon proven developers and contractors with relevant experience. The last thing you want is a developer who absconds with the project’s funds. In general, QOFs don’t fit into a retirement portfolio because of the high risk and fees.
QOFs offer threefold benefits for capital gains you earn.
Deferment of Gains from Other Investments
The first tax benefit is that you can defer federal capital gains from other investments by channeling the money into a QOZ fund. For example, suppose you sold off your Apple stock for a $100,000 long-term capital gain. You have 180 days from the sale date to roll over your capital gain into a QOF. The rollover lets you defer the capital gain until you sell out or December 31, 2026, whichever comes first. In other words, rewards are available if you shunt your capital gains into an OZ and put them to good use. This should make you and your CPA very happy.
Rewards for Long Holding Periods
You can further reduce your rolled-over gains by increasing your holding period. A five-year holding period will earn you a reduction of your taxable gain by 10%. That becomes a 15% reduction on the gain if your hold your investment for seven years. From our example, the $100,000 gain slims down to $85,000 if you stay invested for seven years. Whether you hold or sell your QOF investment in 2026, you’ll have to pay the taxes on the original invested capital gains.
You can avoid all the tax on QOF gains if you hold your investment for 10 years. This works as long as your original investment came 100% from another investment’s capital gain. Most QOFs let you sell out at any time although a few of them do require you to stay invested for 10 years.
How Assets America® Can Help
Since you must invest previous capital gains in a QOF to earn the rich tax breaks, Assets America® really can’t help you, that is, unless you need help moving or selling a commercial real estate property.
Frequently Asked Questions
Do I need to live in a QOZ to gain the tax benefits?
Nobody cares where you live. The only thing that counts is whether the property resides in a QOZ. In other words, it’s not about you, it’s about the property.
What is a Qualified Opportunity Fund?
A qualified opportunity fund is an investment vehicle you can use to invest in a QOZ. A QOF is usually a corporation or a partnership. If you are still confused about QOFs, please go back and reread this article.
What is a deferral of eligible gain?
If you use the capital gains from other investments to fund your QOF investment, the tax on those gains receives a deferral. If you hold the investment for five or more years, you’ll be able to reduce the gain exposed to taxes.
What is a QOZ property?
QOZ property is property owned by a QOZ business. That’s a business that is eligible for inclusion in a QOF. Typically, QOZ property must meet certain criteria related to the date of purchase and how the property will operate.
When is a tangible property a QOZ business property?
This is a property owned by a QOZ business that the QOF purchased before January 1, 2018. The property’s original use started with the QOZ business or underwent substantial improvements by the QOZ business or QOF.