Qualified Opportunity Zones (QOZs) are communities that Congress designated as economically distressed as part of the Tax Cuts and Jobs Act (TCJA) of 2017. QOZs offer investors a chance to reinvest proceeds from property sales into businesses that engage in redevelopment projects in those strategic areas. The incentive is that gross income from capital gains on property sales or 1031 exchanges does not get taxed when investing entities meet the criteria outlined by IRS rules.
The tax deferment only works when investors reinvest gross income from the previous sale of a property. New investment capital in QOZs does not qualify as tax-deferred investments. If you’re considering QOZs as a potential investment opportunity, here’s what you need to know.
Who Qualifies for the Benefits of Investing in QOZs?
The IRS allows a wide range of persons to benefit from investing in QOZs. The list includes:
- C corporations
- Regulated investment companies (RICs)
- Real estate investment trusts (REITs)
- Partnerships
- S corporations
- Trusts and estates
Just like 1031 exchanges, property investors have up to 180 days to reinvest gross income from capital gains on sales and exchanges in QOZ properties without being taxed. The government has set a time limit of December 31, 2026, for the reinvestment to occur if the investment property has not already been sold. You need to invest in the property for at least five years to qualify for tax incentives. To make the most of the potential tax gain, you need to hold on to the property for 10 years.
To be considered in a qualified opportunity zone, a property needs to be in a location that the U.S. Census Bureau has deemed an economically distressed area. You can find a spreadsheet listing the population census tracts that meet QOZ requirements from the Community Development Financial Institutions Fund. QOZs exist in all 50 states and in five U.S. territories. You don’t currently need to live or work in a QOZ to take advantage of the tax incentives. You simply need to invest a recognized eligible tax gain in the fund and defer tax on it.
QOZs have purchase requirements. For example, you can’t purchase property for or from a relative. You have the option of leasing rather than purchasing equipment, such as building or landscaping equipment, for use in the QOZ.
As an investor, you should be aware of inclusion events, which can trigger a capital gain recognition prematurely. Check with an investment advisor or tax expert to become familiar with all the rules regulating special tax treatment within QOZs. Also, make note of the gross income test. Every year, a QOZ business needs to earn at least half of the amount of its business income from activities within the zone.
QOZ Investment Horizons and IRS Forms
Once you reach the five-year mark, the IRS allows you to retain a partial tax benefit. Beginning with a $0 value basis, if you sell after five years, 90% of the capital gain attribution of your investment becomes recognized. At seven years, the IRS only recognizes 85% of the capital gain attribution. If you hold your investment for a full 10 years, any gains from the investment will be tax-free. You will receive a basis adjustment in the QOZ based on the current market value of the property, meaning you will technically have no taxable capital gain. The National Association of Realtors (NAR) provides its interpretation of some QOZ scenarios as well.
You will need to fill out Form 8949 with your income tax return to record the untaxed gains for which you qualify. Every investment partner must receive a record of capital gains attributable to the QOZ investment. If you are a capital manager or principal investor, then you must distribute Form 1099-B to all investors or partners when a property is sold or disposed of.
Filing to Become a Qualified Opportunity Fund (QOF)
Before partnerships or corporations can begin acquiring QOZ property, they must self-certify on Form 8996 of an intent to create a qualified opportunity fund (QOF). A QOF is an entity that files a corporate or partnership income tax return. QOFs exist for the purpose of investing in QOZ property. Ninety percent of holdings for a QOF must be assets within a qualified opportunity zone property. Three types of assets with interests qualify as a QOZ:
- Stock
- Partnership interests
- Business property
Secondary QOZ Investing
The IRS allows you to track the reinvestment of gross capital gains from the sale or exchange of one or more QOZ properties into another QOZ. It doesn’t matter what QOZ you choose; you must reinvest within 180 days as you did with the original QOF.
Record the original gains that you reinvested in the first property. When the time comes for you to sell the newer investment, the difference between the purchase price and the appreciation of the asset becomes the new (secondary) capital gains. You have the option to defer all or part of the capital gains from the secondary investment. If you receive income distributions over the life of the investment, you will likely pay taxes which will depend on the kind of business it is.
Concerns and Drawbacks of QOZs
Forbes suggests a word of caution on QOZ investing. Here’s one example. A properly executed multifamily property venture can be developed and sold in under five years. If the managing partners wanted to sell the property after five years, they would only be able to reap a 10% reduction in taxable capital gains for their partners.
Let’s consider a repositioning scenario. If a capital manager purchases a Class “C” multifamily property to renovate and reposition it as a Class “B” building within a QOZ to sell at seven years, private investors would realize only a 15% reduction in taxable capital gains. Rental income from a QOZ property may not be considered a QOZ qualifying service business. You may be taxed on earnings like a non-QOZ area.
A Better Way to Invest in Real Estate
If you want to invest, real estate is often the way to go — but it’s important to choose investments that will help your bottom line and provide the most capital gains and dividends. The wealth managers at SD Mayer can help you to determine what classes of real estate can add diversification and value to your portfolio so you can start investing. The best advisors in business have a holistic view of your overall goals for wealth generation or preservation long-term and can help you figure out which investments will suit you best.
DISCLAIMER:
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The services of an appropriate professional should be sought regarding your individual situation.
