Qualified Opportunity Funds

What is the opportunity?

If you are selling or have sold your business, stocks, bonds, or real estate at a profit, there are significant tax savings if invest the gain from the sale into a Qualified Opportunity Fund (“QOF”). The monies invested in a QOF are used to acquire real estate located in an Opportunity Zone (“OZ”), which are geographic areas of a state designated for economic stimulus. To be eligible, within 180 days of the sale, you must rollover the gain’s portion of the sale into an Opportunity Fund. Investments acquired in the fund produce significant tax advantages if held long-term.

What is an Opportunity Fund?

An Opportunity Fund is an investment vehicle (corporation, LLC, or partnership) established exclusively for the purpose of investing in Opportunity Zones: areas designated by the governor of each state as deserving of economic stimulus. An Opportunity Fund can either invest in a pooled portfolio of real estate or a single property/project. Investors cannot invest directly into real estate located in an Opportunity Zone (8,700 OZs across the U.S.), but into a QOF, which in turn invests in properties located in OZs. The real estate acquired must be used in a trade or business. A QOF can’t just buy and hold real estate, but must make substantial improvements (equal or exceeding the initial investment in the property) to the property following acquisition. Therefore, most all real estate QOFs will be development projects from the ground up. Only cash may be invested in a QOF; no in-kind investments will qualify for the tax benefits.

What are the tax benefits of investing in an Opportunity Zone?

The QOF tax incentives are designed to encourage investors to redirect gain from prior investments into investments in Opportunity Zones. Sellers will be able to defer, and in some cases permanently exclude, certain gains by investing in a Qualified Opportunity Fund. All cash invested from gains into a QOF have a zero-cost basis. There are four primary tax benefits when investing your capital gains into an Opportunity Fund:

Deferment & Reduction of the Gain on your Present Sale

  1. Deferment of capital gains taxes until you exit the fund or December 31, 2026, whichever occurs first.
  2. If the fund is held for 5 years, you receive a step-up in basis of 10.
  3. If the fund is held 7 years or longer, you receive another 5% increase in the basis. Therefore, when you eventually pay the tax in April 2027, you will only have to pay 85% of what you would have paid April 2019.

Tax Forgiveness on any Appreciation in the Value of the Fund

If an investor in a QOF holds their interest in the fund for 10 years or longer, the investor will not recognize gain and will not owe tax on the sale of its QOF interest. For example, if a seller of a business or stock, invests the capital gains portion of their sale into a QOF at $10/share, and 10 years later those shares are sold at $20/share, the new basis of the shares is $20/share; therefore, no tax is owed on the $10/share gain. In essence, all the gain on the acquired shares is tax-free if held and sold at least 10 years from the date of purchase.

How did Opportunity Funds come about?

Opportunity Funds were added when Congress passed the Tax Cuts and Jobs Act on Dec. 22, 2017, to encourage economic development in lower income communities throughout the U.S. Accordingly, states submitted their recommendations to the U.S. Treasury for areas of their state they wanted designated as Qualified Opportunity Zones, in order to stimulate economic revitalization. Once approved, a Qualified Opportunity Zone retains this designation for ten years.

What is an Opportunity Zone?

An Opportunity Zone is a geographical area submitted by a state and approved by the feds, as qualifying for special tax treatment for investors in an Opportunity Fund.

Where are these Zones located?

Every state has designated Opportunity Zones. It is important to verify before investing in an Opportunity Fund that the fund has or will limit their investing to clearly defined Opportunity Zones.

What qualifies for investment in an Opportunity Zone?

Tangible property located in an OZ and acquired after December 31, 2017 and before December 31, 2026, qualifies for QOF investment, if the property is used in an OZ trade or business. The use of the property must originate with the fund, or the fund “substantially improves” the property. Property is considered substantially improved if during any 30-month period beginning after the date of acquisition, improvements to the property exceed an amount equal to the cost paid for the property by the fund. For example, if the original use of the property does not begin with the fund and the fund acquired the property for $75,000, then it is required to invest an additional $75,000 into the property in order for it to qualify as Qualified Opportunity Zone Business Property. Note that there is no limitation preventing the Fund from borrowing cash in order to purchase or improve the property.

Example

On May 1, 2018, Susan sells her high-tech business for $10 million of which $5 million is capital gains. The approximate $1.25 million of capital gains tax is due no later than April 15, 2019.

A couple months later she is meeting with her accountant who tells her about Opportunity Funds. As she begins to understand the new concept she asks, “Are you telling me if I invest the capital gains portion of my sale, into one of these funds, I won’t have to pay the $1.25 million tax liability until April 15, 2027?” Her CPA replies, “Not only that, if you hold the fund until then, you will only owe $1,062,500, instead of the original $1.25 million. 15% of the tax will have been forgiven.”

“To make sure I understand, if I invest in an Opportunity Fund and the Fund invests in real estate located in certain designated areas, I have full use of my capital for over 8 years before the tax on my sale is due; and when I do pay, I only owe 85% of the original tax?” The CPA goes on to explain that if the real estate acquired with her money is held in the fund 10 years or longer, the gain on that is tax free.