Qualified Opportunity Zones: What Investors Need to Know
The Qualified Opportunity Zone (QOZ) program, established in 2017 as part of the Tax Cuts and Jobs Act, focuses on economically challenged communities and census tracts across the country. Opportunity zones incentivize investors to allocate funds to spur development and job creation in exchange for a temporary tax deferral and, ultimately, complete tax elimination.
Approximately 8,700 opportunity zones have been identified nationwide. These zones, initially based on 2010 census data, remain consistent with 2020 census data and are a subset of low-income census tracts and certain adjacent census tracts. Investments in opportunity zones are typically expected to be held for ten years or more and may require additional tax advice during the holding period and upon exit. The tax benefits of the opportunity zone program are scheduled to end in December 2047.
Defer Taxes on Capital Gains Until 2026
The tax benefits of investing in QOZs can be attractive for those with capital gains. Investors who have realized gains must place these gains into a qualified opportunity fund within 180 days from the sale or exchange date of the appreciated asset. The cost basis of the property is determined to be equal to the fair market value on the date of sale, and no tax is calculated on the asset's appreciation. The original capital invested in a QOZ (the realized gains) will not be taxed until year-end 2026, or until the fund is sold or exchanged, whichever comes first. Additionally, investors can receive full capital gains tax elimination on the QOZ investment after a 10-year hold.
For example, if $1 million in capital gains is realized from an asset sale, the tax on this deferred gain would be calculated as 26% of $1,000,000, or $260,000, due in 2026. After a 10-year hold period on the QOZ investment, the investment benefits from complete tax elimination.
QOZs are Impactful Investments
QOZs experienced a 16 percent increase in equity raised from December 31, 2021, to March 31, 2022, reaching $28.37 billion. Development in a QOZ aims to produce growth and revive the affected immediate economy. U.S. Census data and analysis support the idea that investments into QOZs are generally expected to create new jobs, provide affordable housing options, and support various ventures in both rural and urban areas.
According to the U.S. Census, the median family income (MFI) for the average opportunity zone is two-thirds the national MFI ($50,000 versus $77,000), with a poverty rate of 26.4 percent, compared to 13.4 percent for the average U.S. census tract. A total of 31.5 million people across the United States live in areas designated as opportunity zones.
Important Risk Factors to Consider
Investing in IPC-sponsored programs carries various risks, including:
Lack of Public Market: Currently, no public market exists for the interests of any IPC-sponsored program, and one may never exist.
Speculative Investment: Purchasing interests in these programs is speculative and suitable only for individuals who do not require liquidity and can afford to lose their entire investment.
Transfer Restrictions: IPC-sponsored programs offer and sell interests under exemptions from federal and state registration provisions, meaning these interests are subject to transfer restrictions.
No Guarantee of Objectives or Distributions: There is no guarantee that the investment objectives of any particular IPC-sponsored program will be achieved. The actual amount and timing of distributions are not guaranteed and may vary, and there is no guarantee investors will receive distributions or a return of their capital.
Real Estate Risks: Investments in real estate are subject to various risks, such as local conditions (oversupply or reduced demand), inability to collect rent, vacancies, inflation and increased operating costs, adverse changes in laws and regulations, and changing market demographics.
Tenant Dependence: IPC-sponsored programs rely on tenants for revenue and may suffer adverse consequences from financial difficulties, bankruptcy, or insolvency of their tenants.
Single-Tenant Properties: Programs may own single-tenant properties, which can be difficult to re-lease upon tenant defaults or early lease terminations.
Economic Conditions: Disruptions in financial markets and challenging economic conditions, including those resulting from the COVID-19 pandemic, could negatively affect the operating results of properties owned by IPC-sponsored programs and their ability to service debt.
Past Performance: The prior performance of other programs sponsored by IPC should not be used to predict the results of future programs. Some previously sponsored programs have experienced adverse developments.
QOZ-Specific Risk Factors
There are substantial risks associated with the U.S. federal income tax aspects of purchasing interests in a qualified opportunity fund. Prospective investors should consult and rely on their own tax advisors.
Lack of Precedent and Guidance: There is a lack of precedent and limited guidance related to qualified opportunity funds.
Failure to Qualify: A program intended to qualify as a qualified opportunity fund may not do so for various reasons, including failure to substantially improve the property within the first 30 months of operation. If a fund does not qualify, no deferral or elimination of taxable gain will be available to its members.
Automatic Gain Recognition: Investors holding interests in a qualified opportunity fund through December 31, 2026, who deferred gain by acquiring such interests, will automatically recognize some or all of the federal income tax gain they deferred on December 31, 2026.
Unclear State and Local Tax Implications: The state, local, and other tax implications of a qualified opportunity zone investment are unclear.
This article was originally published by Inland Securities.