One of the many details buried within the 2017 Tax Cuts and Jobs act is the establishment of Qualified Opportunity Zones (QOZ). Below, we explore the details and potential tax benefits of QOZs.
What is a Qualified Opportunity Zone?
QOZs are economically distressed communities selected for revitalization and redevelopment. These communities are selected by state governments but generally, the selected zone must have (1) a poverty rate of at least 20% or (2) a median family income less than 80% of the surrounding area. There are currently about 8,700 zones identified throughout the country. An investment in a QOZ effectively means the purchase of real estate within one of these zones.
What are the potential tax benefits of investing in a QOZ?
QOZs give investors the opportunity to reduce and defer capital gains, resulting from the sale of an existing investment, until 2026 by way of investment in a QOZ fund. A QOZ fund is simply an entity that is pursuing investment in QOZs. An investor must move the proceeds of an asset sale into a QOZ fund within 180 days of sale to avoid capital gains tax. If the QOZ fund is held for five years, the investor’s capital gain is decreased by 10%. If held for an additional two years, there is another 5% decrease in capital gain. Also, the QOZ fund investment enjoys tax free growth if held for a total of 10 years.
You purchased an investment property for $500,000 and plan to sell it for $700,000. If sold outright, the capital gain of $200,000 would be taxable (federal and state – for taxpayers at the highest marginal rates, this could be as high as 33.2%). Instead, you decide to reinvest the $700,000 of proceeds in a QOZ fund. After the first five years, your capital gain is reduced to $180,000. After two more years, the capital gain is reduced to $170,000. In three years, you will have held the QOZ fund investment for a total of ten years. Your investment in the QOZ fund is now worth $800,000. The $100,000 gain on the QOZ fund is tax-free and you’ve reduced your capital gain on the original asset sale by $30,000, saving $9,960 for an investor in the highest marginal tax bracket.
What are the risks?
By definition, QOZs are characterized as being economically distressed areas. Not all 8,700 QOZs are good investments. Like most financial decisions, an investment should not be made solely because of a potential tax benefit. Rather, any investment should first be judged on its own merit. At the QOZ fund level, the usual due diligence should occur including consideration of: fund manager experience, pipeline for investment, fund size, track record, fees, etc.
In summary, Qualified Opportunity Zones offer attractive potential tax incentives. There are still many questions about the technical details of QOZ investments but the IRS has provided some new guidance recently. We would love to partner with you to determine if a QOZ investment fits within your financial plan.