Imagine yourself as a home flipper. You buy 3 properties for $100,000 each and after spending $100,000 on repairs, you sell them for a combined $600,000. After subtracting the cost of renovations, that’s a tidy $200,000 profit. Sounds like the perfect happy ending, right? Well, not exactly.
It’s great that you made money, but now your $200,000 profit is subject to capital gains tax. For years, your best tax-deferral strategy was to complete a 1031 exchange with your capital gains. Today, however, the Tax Cuts and JOBS Act of 2017, gives you another option: investing in an opportunity zone fund.
What is an Opportunity Zone Investment?
Despite the fact that economic indicators like the Dow Jones industrial average and real estate prices have been skyrocketing into the stratosphere, there are still distressed communities in America struggling with systemic poverty and a lack of private investment. Most, if not all, of these low-income communities have been left behind by the post-2008 economic boom.
Residents of these areas suffer from a lack of quality educational and employment opportunities that date back for decades. This has created a long-term poverty cycle that is literally locking millions of hard-working people out of an opportunity to live the American dream. To alleviate this problem and spur investment in these areas, the Tax Cuts and JOBS Act created the concept of opportunity zones. An opportunity zone investment is exactly what it sounds like — a monetary investment made in an opportunity zone.
What Qualifies as an Opportunity Zone?
An opportunity zone can potentially exist in any neighborhood that has been economically depressed for an extended period of time. The governor of every state (and the mayor of Washington, D.C.) can nominate any historically disadvantaged area in their state to be designated as an opportunity zone.
The federal government reviews the nomination and if it's approved, the area will become an opportunity zone. The opportunity zone designation encourages people to make significant investments in the zone such as buying real estate or opening businesses by offering tax incentives and other benefits to investors and business owners.
The U.S. Department of Housing and Urban Development has an opportunity zone map on its website. If you’d like to know what eligible census tracts contain opportunity zones in your state, or anywhere else in the U.S., this is a great place to start your research.
What is an Opportunity Zone Fund?
An opportunity zone fund is an investment vehicle that works a lot like traditional real estate investment trusts (REITs). The fund buys property with the intention of improving it and holding it until the property begins generating income and/or appreciates enough to be sold at a profit. The difference is that opportunity zone funds must make 90% of their investments into designated opportunity zones. REITs on the other hand, can buy, renovate and sell property wherever they like.
Why Should you Invest in Opportunity Zone Funds?
There is an inherent risk that comes with making an investment in a low-income community. It’s no secret these areas suffer from long-term blight, lack of infrastructure and failing schools — all of which heighten risk for investors. This begs the question: Why would you invest in an opportunity zone project when your end goal is not to make a social impact but to make money for yourself and your family?
The simple answer is tax breaks. Whenever you sell real estate (or any other investment) for more than you bought it for, the profit is known as a capital gain. Under current U.S. tax law, long-term capital gains — profit realized on any investment held for longer than 1 calendar year — can be taxed up to 20%.
Under that tax plan, if you bought real estate and held it for 18 months before clearing a $200,000 profit, you could be subject to a $40,000 tax liability. However, if you put your entire $200,000 capital gain into an opportunity zone fund, your $40,000 tax bill would be deferred until you sold your share of the opportunity zone fund.
This gives you a strong incentive as an investor to put your capital gains into an opportunity zone fund. You were going to pay $40,000 in taxes anyway — money that was never going to make you a dime. The logic behind opportunity zone funds is that most investors would jump at the chance to turn a $40,000 tax bill into $40,000 worth of equity in a tax-deferred investment.
That makes investing in opportunity zone funds a great idea for any taxpayer with unrealized capital gains they don’t want classified as taxable income. So, while it might not make sense to invest in a low-income community under normal circumstances, the preferential tax treatment that comes with investing in opportunity zone funds changes the equation significantly.
What Properties Can an Opportunity Fund Invest in?
To claim the tax deferral that comes with opportunity zone investments, the fund must purchase a qualified opportunity zone property. There is more to qualification than a property simply being in an opportunity zone. According to the Tax Cuts and Jobs Act, a qualified opportunity zone property must have been purchased after Dec. 31, 2017.
Properties inside opportunity zones that were purchased before this date can still qualify for the tax break but only if the fund makes what the Tax Cuts and JOBS Act describes as “significant improvement” to the property no later than 30 months after realizing the capital gain. Remember, the ultimate goal of creating an opportunity zone is to encourage investors to make new purchases in opportunity zones, not to renovate properties they were already holding.
One of the main points of focus for opportunity zones is to encourage investments in affordable housing or businesses that will provide workforce housing within the opportunity zone. With that in mind, there are some types of businesses that do not qualify for opportunity zone fund investment regardless of when they were purchased. A partial list of nonqualifying businesses appears below:
- Liquor stores
- Race tracks
- Gambling halls
- Massage parlors
- Golf courses
How to Invest in an Opportunity Zone
While it’s certainly possible for an individual investor to purchase a qualified opportunity zone property, the intense amount of legwork and planning that goes along with these types of investments is better left to experienced professionals. If you want to invest in an opportunity zone, the simplest way to do it is to invest in a qualified opportunity zone fund.
This is a much more user-friendly way for you to make a long-term investment in an opportunity zone. Investing in a fund will give you all the tax-deferral benefits while also sparing you the hard graft of finding a qualifying property and supervising the rehabilitation.
Is an Opportunity Zone Fund Right for you?
There are a number of compelling reasons to invest in an opportunity zone fund. If you look at them from a place of pure self-motivation, the tax-deferral benefits alone are reason enough to strongly consider it. Additionally, the fact that opportunity zones are in markets that have underperformed historically means these investments have tremendous potential upside. This means you can make money and a social impact at the same time, which is a rare feat for any investor.
There are other considerations as well. Opportunity zone fund investments take time to pay off, and there is no guarantee they will. That means you may have to wait a long time before your investment pays off, and it may not be easy to liquidate your opportunity zone investment if you need to. If you’re in a position where you need a more reliable, quick payout on your investment, a traditional 1031 exchange might be a better option.
Are opportunity zones still available in 2022?
Yes, due to bipartisan legislation, opportunity zones are available until 2026.
What does it mean to invest in an opportunity zone?
Opportunity zones allow investors to invest in areas in the U.S. that are distressed.
How do I report an opportunity zone investment on my taxes?
To report an opportunity zone on your taxes, report a sell or exchange on Form 8949, Sales and Other Disposition of Capital Assets.
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