Investing in Qualified Opportunity Zones
By Drew Reynolds
Although a key deadline in the Qualified Opportunity Zone (QOZ) program has passed, there still are many compelling reasons for investors to consider this type of investment vehicle.
Real estate investors who participated in Qualified Opportunity Zone investments have benefitted from the deferral of capital gains taxes and a step-up in basis, and those who commit to holding their investments for at least a decade can realize additional benefits by exiting their QOZ investments completely tax-free.
Drew Reynolds
The step-up in basis portion of the QOZ program expired at the end of 2021, but Qualified Opportunity Zone investments can still prove attractive to investors seeking to defer capital gains – especially in light of an uncertain market with inflationary conditions and recent taxation proposals that would significantly boost the rate at which capital gains are taxed. If tax rates do increase, the QOZ program can potentially provide additional value as investors can reap the benefits of a tax-free exit, which can increase the value of the investment compared to other options.
Let’s take a closer look at why QOZ investments can still be beneficial to certain investors.
7 Potential Benefits of QOZ Investments
Real estate investors with gains to defer may be able to take some chips off the table by investing in Qualified Opportunity Funds since they only need to invest their capital gains – you can pocket your original basis in an investment without generating a taxable event. This strategy can potentially reduce your exposure to risk since you’re banking some of your investment capital.
There are many scenarios where it might make sense for investors to strategically deploy realized capital gains into Qualified Opportunity Funds. Capital gains can be from the sale of an investment property, stock or other type of security, or even the sale of a business – all types of capital gains qualify. QOZ investments have a different investment structure than 1031 exchanges, which are another common tax-deferral tool. With QOZs, investors only need to invest their realized gains, whereas 1031 exchange laws require investors to roll over the entire proceeds from the sale of an investment property.
Here are some potential benefits that may be achieved through QOZ investments:
● Deferral of capital gains. Investors who have recently completed a sale or exchange of real property can reinvest any realized gain in a Qualified Opportunity Fund (QOF) up to 180 days after closing. However, in some circumstances, depending on how an investor files taxes, it may be longer. K-1 partnership gains realized on or after January 1, 2021 have a deadline of September 11, 2022 to complete a QOZ investment (Investing in the Zone, Cantor Fitzgerald . Taxes on those gains can be deferred through the end of 2026.
● Exit tax free. Investors who hold their QOZ investments for 10 years will be able to reap the greatest reward offered by the QOZ program: You can exit your investment without paying any tax on the original investment amount, as well as on any appreciation realized by your QOF interests. The capital gains tax due on the original investment won’t be due until 2026, and then it will be taxed at the current capital gains rate. Most tax-advantaged investment programs offer the opportunity for tax-deferral. QOZ investments, however, offer investors the opportunity for tax elimination without any additional requirements other than meeting the 10-year holding period.
● Potential for greater returns than other tax-deferred investment vehicles. Growth-oriented QOZ investments have the potential to provide greater total returns than other types of tax-deferred investments. Real estate is trading at historically low cap rates, and current cash flows from stabilized real property assets may not be as high as they were just a few years ago. (Property Prices Could Rise With Cap Rates Poised to Fall Even Further, GlobeSt)
The graphic below demonstrates the potential tax advantages of investing in a QOF that could lead to greater yield than with non-qualified opportunity funds.
Source: Cantor Fitzgerald, QOZ vs. Non QOZ Return ComparisonundefinedThis illustration assumes the investor is subject to the top marginal U.S. federal income tax rate of 20% on long-term capital gains for individuals, the net investment income tax of 3.8%, and a state tax of 6.2% for a total tax liability of 30%. No brokerage or investment advisory fees are accounted for with respect to the Non-Qualified Opportunity Fund example above and no distributions made on the Class C common stock, no fees due to our Manager and its affiliates, and no sales commissions, deal manager fees, and non-accountable diligence and marketing allowances due to our ManagingundefinedBroker-Dealer and its affiliates are accounted for with respect to the Qualified Opportunity Fund example.undefined
This illustration assumes that the Qualified Opportunity Zone investor is a resident of a state that conforms with the QOZ Program.undefined
Assumes that the investor has no capital losses to reduce such capital gain and refers to the inclusion of the original, invested capital gains in such investor’s taxable income on December 31, 2026.undefinedThis example assumes the investor does not pass away during the ten-year period. If the investor were to pass away, the heirs receive a step-up in basis in the Non-Qualified Opportunity Fund exampleundefinedand a carryover basis for the Qualified Opportunity Fund example.
● Timing. Completing a 1031 exchange to defer capital gains could prove challenging in hot real estate markets where properties routinely are sold at a premium in off-market deals. There are more than 310 QOFs nationwide where investors can potentially meet the 180-day investment requirement to defer their capital gains. (Directory of Qualified Opportunity Zone Funds, OpportunityDB)
● No need for the step-up in basis. In order to receive a 10% step-up in basis, investors had to achieve a five-year holding period by 2026, so they would have had to record their investments by Dec. 31 of 2021. While the step-up in basis portion of the QOZ program has ended, its impact on investors is modest at best – the larger benefits of tax deferral and the potential for a tax-free exit far outweigh the step-up in basis.
● Tax-free investment growth. The current QOZ program allows investors to keep their money growing tax-free through 2047. However, not every QOZ is structured to be held through 2047, so investors should evaluate the investment’s exit timing. Many investors may choose to unwind their QOZ investments after a decade has passed, but certain funds may allow investors the benefit of growing their investment tax-free through the end of 2047, when all QOF investors will be required to unwind their investments.
● Potential extension of tax incentives. Senators Cory Booker (D-NJ) and Tim Scott (R-SC) introduced a bipartisan bill in early April that would extend the tax incentives of the Opportunity Zone program for two additional years. Booker and Scott originally introduced the Investing in Opportunity Act in 2016, and that bill formed the backbone of the Opportunity Zone program in the 2017 Tax Cuts and Jobs Act. The effective date for investors to realize a 10-percent step up in basis would be extended to Dec. 31, 2028.
The Bottom Line
Qualified Opportunity Zone investments aren’t all the same, and the principles that apply to real estate investing also apply to QOZs. The current trajectories and trends in various sectors of commercial real estate can be extrapolated to potential Qualified Opportunity Zone investments as well.
Whether or not QOZs are a good fit for your investment strategies depends on your individual tax situation, liquidity needs, tolerance for risk, and other important factors. Consulting with financial and real estate professionals can help you think through the implications of investing in a QOZ and determine if this type of investment is right for you.
About the author: Drew Reynolds
Drew Reynolds is chief investment officer and head of research at Realized, a real estate wealthtech firm that provides Investment Property Wealth Management® for investors. Read more about qualified opportunity zones.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation
