Over the past 10 years, many investors have accrued sizable capital gains across their portfolios, thanks to a decade-long bull market and economic expansion. While these earnings would usually be subject to a capital gains tax, financial advisors now have a new tool at their disposal to potentially help clients reduce their capital gains tax burdens, as well as to grow this gain in a tax favorable environment: Qualified Opportunity Zone (QOZ) investing.
What Are Qualified Opportunity Zones?
A provision of the 2017 Tax Cuts and Jobs Act allows investors to gain tax benefits by investing capital gains in real estate in areas designated by states as underdeveloped or economically struggling known as Qualified Opportunity Zones. Clients who invest QOZs can delay payments of the capital gains taxes they would have owed on the original investment, reduce the amount of those payments, and potentially exempt themselves from paying any additional capital gains taxes realized on a QOZ asset.
As of mid-2018, state governors and the U.S. Treasury have designated 8,700 Qualified Opportunity Zones. Investments in these zones have the potential to revitalize poverty-stricken areas, bringing new jobs, businesses and housing to places that desperately need them, which may appeal to socially minded investors.
Opportunity Zone Funds (OZFs) are an investment vehicle formed specifically for the purpose of investing in qualified QOZ assets. Short- and long-term gains from the sale of stocks, bonds, property and interests in partnerships are eligible for investment in an OZF, but how much of a tax advantage an investor stands to gain depends on the amount of time he or she is willing to retain it.
As long as the OZF investment is made within 180 days of the sale of another asset, after five years holding period, the investor will get a 10 percent step-up in basis. After seven years, that increases to a 15 percent step-up. Since the last date for paying taxes on the deferred gain is Dec. 31, 2026, investors will need to be invested in an OZF by Dec. 31, 2019 to realize the maximum step-up benefit of 15 percent. Once the original gain has been invested in an OZF for more than 10 years, the investor will pay no capital gains on any appreciation earned on the original investment. The investor is only responsible for taxes on income from the properties.
Once the OZF acquires the property, the fund manager has 31 months to develop or redevelop the property to improve its cost basis, or risk a penalty. According to federal rules, managers must invest at least as much as the purchase price on improvements to the property or entity in which they’re investing.
What To Consider When Evaluating An Opportunity Zone Fund?
1. Find The Right Manager
When choosing OZFs for client portfolios, due diligence is key. Advisors should consider when evaluating managers, their experience and ability to not only source the best-quality opportunities, but to redevelop and manage them over the long term. When considering a fund, ask yourself: Does the manager have a strong skillset and experience in development and construction? Do they have local relationships in the zone? In similar projects, has the manager partnered with quality developers, and did they meet their timelines? If the answer to any of these questions is no, the success of the investment could be in serious jeopardy.