Qualified Opportunity Zones were created as part of the Tax Cuts and Job Act of 2017.
Opportunity zones are an economic development tool that allows people to invest in distressed areas in the United States. They encourage investment in low-income and underfunded regions. In 2021, there are over 8,700 opportunity zones across the 50 states.
At a fundamental level, opportunity zones are tax incentives that encourage investors with significant unrealized capital gains to invest in distressed areas.
Are opportunity zones an investment worth considering? Let’s find out.
Qualified Opportunity Zones Provide Investment Tax Breaks
The most substantial incentives that draw investors to opportunity zones are certainly tax-related. While investing in a distressed area is undoubtedly a noble cause, the government is aware they need to provide financial incentives to accomplish that goal.
Tax Benefits Breakdown
- Existing Capital Gains: If you have investments with unrealized capital gains, you can invest those assets in an opportunity fund and defer the realization of those gains until December of 2026.
- Step Up in Basis: If you plan on investing in these zones for the long term, the tax benefits get even more appealing. For capital gains invested in the zones for at least 5 years, a 10% step-up of cost basis is applied. If held for 7 years, a 15% step-up applies. For example, if you have an investment with a cost basis of $100 and a value of $150 (with a $50 unrealized gain), the cost basis would step up to $110 (10%) after 5 years and $115 (15%) after 7 years. This is significant on more considerable sums of money.
- Exclusion of Future Gains: For investments made within the opportunity fund (not investments previously contributed) and held for at least 10 years, investors pay zero taxes on any gains. This provision is particularly appealing to investors who genuinely believe in the long-term investment in these communities.
A Comparison: QOZ vs Non-QOZ
Below is a hypothetical comparison of investment returns for both a Qualified Opportunity Zone investment and an investment made in a taxable brokerage account.
|Qualified Opportunity Zone||Taxable Investment|
|Original Capital Gain||$1,000,000||$1,000,000|
|x Tax Rate||35%||35%|
|- Capital Gains Tax Due||Deferred Until Dec. 2026||($350,000)|
|= Investable Amount (after tax)||$1,000,000||$650,000|
|x Compounded Hypothetical Annual Return Rate||7%||7%|
|= Appreciation (over 10 years)||$967,151||$628,648|
|- LT cap gains tax on the original capital gain (due in 2027)||($315,000)*||$0|
|- Tax on the appreciation over 10 years||$0||($220,027)|
|= Final value (net of taxes after 10 years)||$652,151||$408,621|
* The deferred original capital gains gets a 10% step-up in basis
How to Invest in a Qualified Opportunity Zone
The most common way to invest in a qualified opportunity zone is via a qualified opportunity fund. These funds facilitate the investment in opportunity zones and are created by a corporation or partnership that qualifies its fund via IRS Form 8996.
These funds are required to make substantial improvements to the properties in which they invest. At least 90% of the fund assets must consist of qualified opportunity zone properties.
Common Projects in Opportunity Funds:
- Updating vacant homes
- Redeveloping abandoned properties
- Installing environmentally-friendly energy products (i.e., windmills or solar panels)
- Affordable housing projects
Locating and evaluating opportunity funds can be cumbersome. This list of active funds details information, including fund name, fund size, geographic focus, investment focus, and entry date. Unlike investments in the public sector, information is harder to come by, and disclosure protocols are not nearly as streamlined or consistent.
Find the Right Zone and Investment for You
There are a lot of pros and cons to investing in opportunity zones. Ultimately, the decision of whether or not to invest comes down to your unique financial situation.
Reasons to Consider Investing
- You have substantial capital gains and are looking to defer the realization of those gains.
- You believe in the investment strategy. Ultimately, the tax benefits are a moot point if the investment is inadequate. You must do your research and believe in the long-term success of the fund.
- You believe in the cause. Morally, you should believe in the concept of investing in distressed communities. This belief will allow you to invest long-term without getting too discouraged if things don’t go well right away.
Key Risks to Recognize
- Liquidity: Unlike stock market investments, you can’t necessarily sell your assets at the drop of a hat. Many of the investments are tied to real estate and can not easily be sold. Your investment in opportunity funds should probably not contain a large percentage of your net worth.
- Longevity: If you want to realize all of the tax benefits associated with these investments, you will need a long time horizon. Additionally, you may need excess cash on hand to pay capital gains taxes after the 5 or 7 year holding period. At the end of that period, you will still have to pay some amount in taxes and may not be able to liquidate your QOZ investment to cover the cost.
Should You Invest?
Ultimately, Qualified Opportunity Zones are unique investments with significant tax benefits and substantial risk. It’s crucial you deeply understand the cost and benefits before diving in. At Rivermark Wealth, we help our clients make these types of unique decisions. Schedule a call with our team today and discover if opportunity zones fit into your overall financial strategy.