Qualified opportunity funds and opportunity zones go together like peanut butter and jelly. The latter was first made available in 2017, and both of these investment options have opened up new opportunities for investors with the right mindsets to take advantage of them. Through opportunity funds and opportunity zones, you’ll be able to invest in business development or real estate deals and avoid some capital gains taxes or penalties at the same time. Let’s take a closer look at both of these topics and break down how you can use them for your investment goals.
What is an Opportunity Zone?
An “opportunity zone” or OZ is a special development zone created as part of the TCJA or Tax Cut and Jobs Act. The Act was intended to improve the economic development of various depressed areas throughout the country, primarily by offering special tax incentives to investors who use dedicated tax vehicles, qualified opportunity funds, to develop said zones. All OZs are identified by the US Treasury from their low-income census data. There are OZs in all 50 US states and five additional US territories.
What is a Qualified Opportunity Fund?
Qualified opportunity funds are distinct investment vehicles that you can only use to invest in real estate or business development opportunities in the above-described opportunity zones.
Corporations or partnerships can create investment funds, then designate them as qualified opportunity funds simply by filing IRS Form 8996 when they complete their federal income tax returns. By becoming a qualified opportunity fund, the investment fund will get preferential tax treatment for any investments held for at least five years.
To be designated as a qualified opportunity fund, the investment fund must invest at least 90% of its total assets in OZs to receive certain tax breaks. Fortunately, QOFs can invest in various qualifying investments, including businesses, properties, and equipment. But the majority of OZ investment opportunities include residential real estate and commercial developments. In total, QOF investment objectives or developments can include:
- The redevelopment of various abandoned properties for residential use, including office space, retail locations, affordable housing, senior living, and more
- The improvement of blighted and/or vacant single-family rental homes
- The development or improvement of environmental and/or energy products, including utilities, solar and wind power utilities, water plants, urban farming, and more
In short, a qualified opportunity fund can invest in anything that demonstrably improves the opportunity zone and receive tax breaks as a result.
Qualified Opportunity Fund Tax Benefits
Creating a qualified opportunity fund can lead to several major tax benefits/breaks. Additionally, eligible capital gains from investors, including those from real estate, business, stock, and other investments earned before January 1 of 2027, can be rolled into the QOF. The tax benefits of qualified opportunity funds include:
- All taxes on capital gains in a QOF are deferred until either the investment is sold or realized by December 31, 2026, whichever ends up being sooner
- All capital gains invested into the QOF for five years or more have their cost bases reduced by 10%
- If the QOF investments are held for seven years or more, this is further reduced by 15%
- If the QOF investments are held for 10 years or more, investors benefit from a 15% cost basis reduction for the original capital gain amount. They also pay zero capital gain tax on new investment appreciation
In other words, investors gain more tax rewards by holding QOF investments in opportunity zones for longer.
How to Invest in a Qualified Opportunity Fund
In general, investors would be wise to benefit passively from the above-described tax incentives. Place your qualified capital gains into a QOF, or create a new QOF to place future qualified capital gains into the investment fund. A QOF is like a regular investment fund in that it manages your investments and provides a specified return to all participant investors. The capital commitment agreement will break down what return you can expect.
Additionally, keep in mind that you’ll benefit from greater tax breaks if you hold the investments in the qualified opportunity fund for longer periods of time. Do not use QOFs to escape taxes in the short term – it’s better to use these to transfer wealth to the future and do good for underprivileged communities at the same time.
How to Start a Qualified Opportunity Fund
Because creating any type of hedge fund is extremely complicated and expensive, only experienced and active real estate investors should attempt to start their own qualified opportunity funds. However, any company ranging from a partnership to a corporation can become a qualified opportunity fund by filing IRS Form 8996. To do this, the company must file the form for every taxable year it wants to maintain its QOF designation. The fund will also need a management team to ensure that investments are placed in the right areas and that they are held for enough time to benefit from the IRS tax breaks. All QOFs must meet a minimum 90% investment standard within qualified opportunity zone properties.
Furthermore, investment assets must already be established as operating businesses or properties inside an opportunity zone. If the property is not developed or has been abandoned, significant improvements have to be made to the property within 30 days of acquisition, or your QOF may be penalized. The IRS assesses the investment standards for qualified opportunity funds every six months.
Qualified Opportunity Fund Pros & Cons
The benefits of rolling your capital gains or otherwise investing in a qualified opportunity fund are straightforward:
- You get various tax breaks and incentives, especially if you participate for longer stretches of time
- There are currently over 8700 census tracts you can invest in, allowing you to choose opportunity zones that best suit your goals or that resonate the most with you personally
- Your capital gains taxes can be significantly reduced if you participate in qualified opportunity funds if you are patient
On the other hand, QOFs have some potential downsides: All investments carry a minimum five-year investment requirement before you see benefits. Any money placed into a QOF is therefore illiquid. These investment opportunities are limited by their very nature, so you can’t use the money from your capital gains in other places for more direct/short-term profits.
Qualified opportunity funds can be valuable vehicles for real estate investors that want to make the most of their capital gains without being taxed as much as normal. They can also be great vehicles for investors that want to make a real difference in low-income or underprivileged communities. But you should consider whether starting a QOF is a good idea for your investment goals. If you decide to use a QOF, it’s a good idea to reach out to a funds manager to handle the details given these funds’ complexity.