QOZ & OPPORTUNITY FUND: AN INVESTOR’S TAX INCENTIVES GUIDE
This whitepaper discusses how the Qualified Opportunity Zone (QOZ) program works and how it provides potential tax savings to investors. This also serves as your guide in determining if investing in a qualified opportunity zone fits your risk profile and your goal of diversifying your investment (depending on your current financial status).
THE QOZ INCENTIVE PROGRAM
As a mechanism to spur economic development and job creation in low-income communities, Qualified Opportunity Zone (QOZ) incentive program that was created in 2017 as part of the Tax Cuts and Jobs Act (TCJA), aims to help improve new communities that need development while granting investors attractive tax benefits.
AN ATTRACTIVE PROPOSITION FOR INVESTORS
This program has been receiving optimistic outlook as investors look for financial incentives and products that would bring in competitive returns and more diversity in portfolio. Not only it is an attractive proposition for investors given the current climate, but the incentives and flexibilities offered by this program also provide expansive efforts to emerge from the current public health and global economic crises brought about by the Covid-19 pandemic.
THE TAX BENEFITS
Depending on how the QOZ will be used, the potential tax savings are promising. An investor can use the program to have a stricter control over capital gain recognition while a contractor can use the program to gain more capital for new projects.
There are three ways by which a Qualified Opportunity Fund investment offers tax savings:
TAX DEFERRAL UNTIL YEAR 2026
If a taxpayer invests in a Qualified Opportunity Fund within the 180-day period starting on the date of sale or exchange, he may elect to postpone tax on some or all of his capital gain. Whichever comes first, any taxable gain in a Qualified Opportunity Fund will only be recognized on December 31, 2026 (for filing of the 2026 return in 2027) or when the interest of the fund is sold or exchanged.
STEP-UP IN TAX BASIS OF 10% OR UP TO 15% OF DEFERRED GAINS
If a taxpayer invests in a Qualified Opportunity Fund within the 180-day period starting on the date of sale or exchange, he may elect to postpone tax on some or all of his capital gain. Whichever comes first, any taxable gain in a Qualified Opportunity Fund will only be recognized on December 31, 2026 (for filing of the 2026 return in 2027) or when the interest of the fund is sold or exchanged.
ZERO TAX ON APPRECIATION
There is no tax on appreciation if the property is held in the Qualified Opportunity Fund for at least 10 years and the cost basis is the same as that of the fair market value on the date of sale or exchange. This means that the longer you hold an investment, the sweeter your tax benefits would be.
IS THE QOZ INVESTMENT RIGHT FOR YOU?
As an investor, you will surely be lured to invest in unexplored territories given the compelling tax incentives, not to mention how QOZ can help in deferring and reducing capital gains on assets that the investor had to sell to buy an opportunity zone investment and how it can totally remove all capital gains tax on the opportunity zone property.
While this seems to be a promising investment, before investing in QOZs, you have to make sure that you are fully aware of all its intricacies. For anyone investing in QOZs, the property must be on hold for not less than 10 years before you can receive a full tax-exempt status on your investment (in which this waiting time would mean that the real estate market can fluctuate). Possible tax legislation and capital gains rates at the time of sale are crucial factors to consider. More of this will be explained later in this paper.
But if done correctly, with the help of a professional legal and tax counselor like Credo CFOs & CPAs, QOZs promises massive potential to investors. Given the plethora of opportunity zones to choose from (there are about 8,700 opportunities in the US) and the differences in strategic approach for each state and territory, our team at Credo can help you investigate and determine where to put your investment to. We will also help you understand why investing in a QOZ is worth exploring for you.
WHAT IS THE QOZ PROGRAM AND HOW DOES IT WORK FOR YOU?
A taxpayer is given 180 days (from the date of the sale or exchange of valued property to invest the realized capital gain dollars into a Qualified Opportunity Fund) to defer a capital gain (including net [§1231 gains). The fund is then invested in a Qualified Opportunity Zone property. Both the return of principal and the realized capital gain may be invested but only the share of the investment related to the capital gain is qualified for the additional appreciation tax exemption of the Opportunity Zone investment. The Opportunity Zone program permits you to sell valued assets like stocks and reinvest the proceeds in a Qualified Opportunity Fund. Deferring the gain is not constrained by any like-kind property investment.
Regardless of when the entity realized the gain, a taxpayer who obtains a reported capital gain via a flow-through company, like a partnership, S-corporation, or trust/estate, is given 180 days from the end of the calendar year to invest in a Qualified Opportunity Fund. If for example, a partnership company realizes a capital gain in March, each partner’s 180-day triggering date is December 31, and each partner has until June 28 of the following year to make their Qualified Opportunity Zone investment.
WHAT IS A QUALIFIED OPPORTUNITY FUND?
A Qualified Opportunity Fund is any form of a venture vehicle that is created either as a corporation or a partnership to invest in a Qualified Opportunity Zone property and holds at least 90% of its assets in Qualified Opportunity Zone property. The investment in this fund, just like other assets, may gain or decrease in value over time. As the program aims to develop certain locations, it’s safe to assume that the fund will continue to invest in the property in which it’s invested. Once the funds are available, cash flow may occur.
These investments may be risky since Qualified Opportunity Funds are new income tax planning tools and we are yet to see the investment possibilities for taxpayers. Market loss, liquidity risk, and company risk, to name a few, are all potential risks, as are many other sorts of investments. This is the reason why this type of investment might not be suitable for all investors.
WHAT IS A QUALIFIED OPPORTUNITY ZONE PROPERTY?
A Qualified Opportunity Zone property is referred to the asset that falls in the category of a Qualified Opportunity Zone stock, a Qualified Opportunity Zone partnership interest, or a Qualified Opportunity Zone business property that was acquired after December 31, 2017, utilized in a Qualified Opportunity Zone trade or business, or ownership interest in an organization (stock and partnership interests) working with such tangible property.
The Qualified Opportunity Fund, in theory, must bring in additional property to be used in the Opportunity Zone. A fund that merely buys property that is currently in use in the zone will not be eligible unless it makes significant improvements (which must exceed the primary investment for the Qualified Opportunity Fund into the existing property in a 30-month period, taking into account that this investment merely applies to the amount that was paid for the building). Given these parameters, specific businesses like golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, race tracks or other facilities used for gambling, and liquor stores are not eligible Qualified Opportunity Fund investments.
OPPORTUNITY FUND TAX INCENTIVES EXPLAINED
Provided that all conditions above are met, investors may benefit from immediate tax deferral and substantial tax return on long-dated investments.
Any investment gain is subject to the gain deferral (like the sale of a valued stock or a business). It’s worth noting that the tax can’t be deferred for an indefinite period; it can only be deferred until the end of 2026. However, the tax savings may still be large. There is no need for an intermediary to qualify for deferral, and the taxpayer is given 180 days from the sale date to invest the gains in a Qualified Opportunity Fund.
The joint application of the “five-year, 10% basis increase” and the “seven-year, 5% basis increase” calls for the triggering of a taxpayer’s gain and a subsequent Qualified Opportunity Zone investment all occurring before the end of 2019. Taxpayers can still take advantage of the “five-year, 10% basis increase” until December 31, 2021.
SAMPLE INVESTMENT AND TAX BENEFITS COMPUTATION
As explained above, investors who hold their stakes in Opportunity Funds over the long term (like 10 years or more) accrue the greatest benefits. Here’s a sample computation outlining the key components of OZ benefits and comparing it with a non-OZ option. This comparison uses the after-tax capital gain amount that is eligible for investing. It also shows the rate of return that is needed on a non-OZ investment to gain the equivalent after-tax proceeds as that of the OZ investment after 10 years.
In this sample analysis, an investor invests $1.5 million at a projected annual increase in value of 12% with gross proceeds at the time of sale after 10 years is $4,658,772. Assuming there is no change in tax rates, a non-OZ investment needs to have an 18% annual increase in value to yield the same amount of after-tax cash proceeds after 10 years. Using the same assumptions but a future federal cap gain increase rate of 35% (from 20%), a 19.73% project return would be needed for the non-OZ investment to gain the same amount of cash as that of the 12% OZ investment.
COMPARISON OF OPPORTUNITY ZONE vs. NON-OPPORTUNITY ZONE INVESTMENT
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