QOZ's are communities that the government offers tax incentives to attract investors to boost job growth and economic development, but should you invest?
The Tax Cuts and Jobs Act of 2017 created tax incentives for business and real estate investments in so-called “opportunity zones”—economically distressed communities that the federal government has recognized as in need of investment.
Since then, more than 8,700 Opportunity Zones have been established in every state and territory. The aim of the program is to catalyze job growth and economic development in these low-income communities by making it more valuable for investors to put their money there (giving them the ability to minimize taxes on eligible investments).
The Opportunity Zone program has come under scrutiny, however, leading some to question how long it will be around. And while the tax benefits of investing in Opportunity Zone communities can be significant, they got a little less advantageous at the start of the year: On January 1, 2020, some of investors’ ability to defer or forgo capital gains tax diminished.
All investors have to decide for themselves if Opportunity Zone “opportunities” (like any others) are a fit for their portfolio. As they do, here are some unique considerations to keep in mind.
Keys to ‘QOF’ Participation
For starters, investors should know that each Opportunity Zone is a geographically-defined community identifiable by its census tract. Localities are nominated for the Opportunity Zone designation by their state, with requests assessed and approved by the IRS.
No more than 25% of the total number of eligible census tracts per state can become Qualified Opportunity Zones (QOZs). A census tract is eligible for QOZ designation if it 1) meets the criteria for a low-income community (LIC) defined in the U.S. tax code, or 2) is contiguous with a LIC QOZ, and has a median income that does not exceed 125% of that neighboring census tract.
A list of designated QOZs, maps of their census tracts, and other information on the Opportunity Zone program is available from the IRS.
Taking advantage of the program’s tax benefits requires investing through a pooled private-sector investment vehicle known as a "QOF" or "qualified opportunity zone fund." Sometimes structured as a corporation or partnership, the QOF must invest at least 90% of its capital in qualifying assets in Opportunity Zones. (Qualifying assets can include operating businesses, equipment, and real property.)
Depending on an investor’s or fund’s time horizon, tax benefits can take several different forms:
- Temporary tax deferral for capital gains reinvested into an Opportunity Fund within 180 days of the sale. Investors can defer tax payments until December 31, 2026, or until the day their stake in QOF is sold or exchanged—whichever is earlier.
- A step-up in basis for capital gains reinvested in an Opportunity Fund, with the greatest benefits for the longest-held investments.
- If the investment is held for five years, investors see a 10% reduction on the gain they’ll owe taxes on. If they hold for seven years, they’ll get another 5% reduction—though this ability is now only available to existing QOF investors (as December 2026 is less than seven years away).
- Investors receive a permanent exclusion from taxable income on capital gains from the sale or exchange of an investment in a QOF if the investment is held at least 10 years.
Concerns to Keep in Mind
The lack of a seven-year sale benefit is not the only reason investors might reconsider the advantages of QOF investing. The program is also being investigated by the U.S. Treasury Department, on the heels of news reports that spotlighted how it’s facilitating tax-free investments in non-community-serving projects (such as high-end apartment buildings and hotels).
There’s little data to prove how widespread or impactful such practices are. No data exists on where investments are being made, so no figures can bear out the effect the program is having on designated communities.
Some argue that the prevalence of the program’s use for multi-million properties is the result of the IRS’ slow movement creating the formal regulations for QOF investing. These final guidelines were not released until late 2019, more than a year out from the draft regulations; retail banks and local-community investment groups may have been more reticent than large institutions (and high net worth investors) to plug resources into the program in the absence of defined rules.
Whether investors pursue these or other kinds of opportunities, and to what degree, should depend on their goals (and their comfort level with the program’s status with Treasury). As with any investment, the market fundamentals of each opportunity and the overall strategy of the fund will affect viability and potential for returns.
Opportunities in Flux
The future of Opportunity Zone investing remains to be seen. The release of the new regulations (or any data to emerge about their impact) may catalyze more activity in the space, for example. Alternatively, concerns about the program’s application to date may grow—leading to program changes, potential restrictions, or more limited availability of opportunities to participate.
Regardless, institutions involved in QOZ investing should be willing to answer investors’ questions and respond to concerns in a straightforward way. As always, it’s best to learn as much as possible to know how QOF participation plays into one’s overall portfolio strategy.