Attention real estate investors: If you’re considering a new investment in a Qualified Opportunity Zone Fund this coming year, keep reading.
To provide some background, Opportunity Zones are economically distressed communities where new investments are eligible for favorable tax incentives. The Tax Cuts and Jobs Act included them in the tax code on December 22, 2017. Currently, there are approximately 8,700 Opportunity Zones across the US. Every major city has at least one opportunity zone and they also exist in suburban areas. If you’re interested in knowing where Opportunity Zones are located, a full list can be found here.
Related: Investing in Opportunity Zones: A Creative RE Investment?
Opportunity Zones were created to spur economic development and job creation by providing tax benefits to real estate investors to encourage them to sell their appreciated investments and reinvest their capital gains in areas in need of revitalization. To invest in such places, however, investment must be made through a Qualified Opportunity Zone Fund.
What Is a Qualified Opportunity Zone Fund?
A Qualified Opportunity Zone Fund (Opportunity Fund for short) is an investment vehicle organized as a partnership or a corporation for utilizing an investor’s capital gains to invest in real estate property located in an Opportunity Zone. In order for the fund to be qualified, it must invest at least 90% of its capital in Opportunity Zone property. How does this work?
Basically, a real estate investor can sell his/her investment property and reinvest any amount of the gains into an Opportunity Fund within 180 days of the sale. Just like in a 1031 exchange, the real estate investor can now defer paying capital gains taxes. What’s great about this is that, unlike the 1031 exchange, capital gains can be from any type of investment. For example, say you’re not originally investing in a real estate property but rather in stocks. If you had major gains from a sale from this type of investment, you can also reinvest them in a Qualified Opportunity Zone Fund to reduce some of your capital gains tax!
Today, investors from across the US housing market are considering making this type of investment for 2019. Should you? Let’s further discuss the tax benefits in addition to the potential risks of investing in an Opportunity Fund to help you make an informed decision.
Disclaimer: This post is for informational and educational purposes only. Please consult your financial advisor for appropriate financial advice before making any investment decision.
Tax Benefits of Investing in a Qualified Opportunity Zone Fund
Normally upon the sale of an investment, investors are immediately subject to capital gains tax. However, if instead a real estate investor takes that capital gain and reinvests it in an Opportunity Zone property within 180 days of the sale, the capital gains tax is deferred temporarily – until 2026. Opportunity Funds provide three types of permanent tax exclusion depending on how long you hold your investment:
- 10% Tax Exclusion: If the investor holds the money in an Opportunity Fund for at least 5 years, he/she can exclude 10% of taxable gains from the original investment amount.
- 15% Tax Exclusion: If you hold the money in the Opportunity Fund investment for at least 7 years, there is an additional 5% exclusion in tax (for a total of %15) of the original investment amount.
- 100% Tax Exclusion: If you hold the money for at least 10 years, all capital gains that you earn and appreciation in the Opportunity Fund investment is tax-free. Thus, if the investment goes well and doubles in 10 years, any gain you get from the sale or exchange of an investment in the Opportunity Fund is tax-free and you can exclude the taxation on any appreciation.
For more details, read: What Are the Benefits of Investing in Real Estate in an Opportunity Zone?
In order to be eligible for the 15% tax exclusion, investors must invest in a Qualified Opportunity Zone Fund by December 31, 2019. When the tax is due at the end of 2026, the investor would have held the investment for 7 years. So if you want to take full advantage of these tax benefits, you should consider selling your investment property and reinvesting the gains in an Opportunity Fund before the end of 2019!
Looking to invest in an Opportunity Zone property? Check out Mashvisor’s predictive analytics for that neighborhood or area to analyze and estimate the potential profits you can make from investment properties there. Click here to get started.
What’s the Catch?
This might sound too good to be true, which means there must be some sort of a catch, right? Well, this type of investment is not for everyone. For now, only accredited investors can invest in these funds. An accredited investor is someone who has a net worth greater than $1 million excluding the value of his/her primary residence, or has an annual income of at least $200,000 for the last two years (or $300,000 combined income if married) and the expectation to make the same amount this year.
Moreover, just like any type of investment, investing in a Qualified Opportunity Zone Fund is not free of risks. There are 2 main risks a real estate investor should be aware of before reinvesting capital gains in these funds:
1. Market Risk:
As we said, investment properties in Opportunity Zones are geographically constrained to distressed communities, which can bring certain challenges and risks to the investment. Because these areas need revitalization, factors like lower population and job growth can stand in the way of an investment’s success.
An Opportunity Fund invests in these communities to attract businesses. However, if future demand doesn’t occur as anticipated, the investment can fail. For example, if a fund is investing in hotel construction in an Opportunity Zone where there is not enough demand from business travelers or tourists to fill the rooms, the hotel’s profitability will suffer.
On the other hand, if a Qualified Opportunity Zone Fund invests in a geographically expanding, up-and-coming community with a solid economy, real estate investors can expect to see profits when the area is revitalized. Therefore, it’s crucial for investors to be careful when selecting which fund to invest in and make sure the fund is investing in the right Opportunity Zone.
For example, the return on investment on Opportunity Zone properties is (9.8%) in Bolivar County, Mississippi, (8.5%) in Wilcox County, Alabama and (6.9%) in Dallas County, Alabama. This data is according to Mashvisor’s Investment Property Calculator and real estate analytics. Interested in using this tool to analyze Opportunity Zones in different neighborhoods across the US? Start out your 14-day free trial with Mashvisor now!
2. Investment Risk:
Most Opportunity Funds invest in developing ground-up apartment buildings, office buildings, or hotels. Generally, these ground-up developments are riskier than the buy-and-hold real estate strategy or value-add projects like fixer uppers. In addition, similar to other investment strategies, an Opportunity Fund investment may increase or decrease in value over the holding period.
If you’re not up to investing in an Opportunity Zone property, read “The Top Real Estate Investment Strategies in Today’s Market” to see which one is best for you instead.
In addition, the IRS and Department of Treasury are still working on issuing regulations and specifics of how Opportunity Funds will work over time. There are still a number of technical matters and questions to answer before an investor pursues a Qualified Opportunity Zone Fund investment. For example, it’s not clear how soon after funds receive an investment must they invest it in an Opportunity Zone property.
Until the Treasury Department provides further details, many investors won’t proceed with an Opportunity Fund investment simply because they don’t know if their investment will actually qualify. Clarity could come over the next months, so you should keep an eye out for additional legal guidance and regularly check the Department of Treasury’s related FAQs for any updates.
Should You Invest?
Opportunity Zone investments have the potential to make attractive profits in the long run. While investing your money in a Qualified Opportunity Zone Fund has substantial tax benefits for capital gains, you still need to be aware of the risks. In addition, this type of investment is not appropriate for every investor. So, if you’re an accredited investor with a high tolerance for risk, proceed with caution and make sure you invest before the end of 2019.
On the other hand, if you think an Opportunity Zone investment doesn’t fit with your real estate profile, we recommend buying an investment property to rent out as a more suitable and safer investment strategy. This we can help you with! Sign up with Mashvisor and use our Property Finder to find profitable properties in any city and neighborhood across the US housing market in a matter of minutes! To learn more about how we’ll help you as a real estate investor, schedule a demo.