Opportunity Zones have certainly been a hot topic since Congress passed this incentive under the Tax Cut & Jobs Act. Investment of gain proceeds into a Qualified Opportunity Zone Fund (QOF) within 180 days of a taxable gain event such as a stock or real estate sale can defer capital gain recognition until as late as December 31, 2026 while also reducing the taxable portion of that deferred gain by up to 15%. Additionally, investors who hold their QOF investment for at least 10 years can avoid tax on the QOF appreciation when liquidating after that point.
With so much tax savings potential for many taxpayers it’s not surprising that many fund sponsors have raced to develop QOF models to accommodate prospective investors. CoNexus’s tax advisory team has reviewed many of these over the past year or so. Most QOFs that we’ve seen have minimum investments between $100,000 – $500,000, although some may be as low as $50,000 or as high as $1 mil.
The vast majority of QOFs we’ve seen are real estate investments, where the existing or target property is geographically located in an Opportunity Zone. Real estate QOFs can involve a single development project, a series of projects in multiple expected high-growth markets, or in some cases a diversified “blind” basket of projects spread across hundreds of markets. A challenge for many real estate funds has been timing, given where the U.S. is in its real estate and economic cycle that has seen a huge run-up in prices over the past 10 years. Finding value in real estate investments can be difficult right now, even in some Opportunity Zones where economic growth and real estate values have lagged other areas somewhat.
More recently we have seen other types of private equity Opportunity Zone funds emerge that aren’t so directly tied to real estate markets but are rather tied to certain target businesses or industries, giving investors more options and flexibility to manage risk and pick investments that fit their portfolio allocation desires.
While tax savings from QOFs can be enticing, we view them more as an investment play than a tax play. If the fund doesn’t perform well or loses value, then deferral and 15% reduction on deferred capital gains tend to lose their luster. And any gain avoidance on fund appreciation over 10 years would be moot.
Another challenge with QOFs has been interpreting the statute. Many questions quickly come into play, such as what happens when an investor dies while holding a QOF investment or gifts their QOF units to a family member? How does a QOF meet all the tests for holding 90% of their assets in Qualified Opportunity Zone Property? How does a QOF or Qualified Opportunity Zone Business subsidiary of a QOF meet the substantial improvement requirements on purchased assets, including raw land? And when does the 180-day clock start running for investment when the gain that a taxpayer wishes to defer is flowing from a partnership or S-Corporation Schedule K-1?
Fortunately, Treasury has issued two rounds of proposed regulations to answer these questions and many others. Yet these are only proposed, not final regulations, meaning they hold limited weight. And more questions remain, giving some taxpayers pause before committing substantial dollars to a QOF investment in certain situations.
Taxpayers with substantial 2019 realized capital gains certainly may want to consider QOF investment options, but investment due diligence is key. Prospective investors should evaluate portfolio fit, expected timing, tax character and amounts of all investment returns, risks, fees, and other factors with their financial advisory team, including tax advisors to help ensure that any investments are timed and structured properly to achieve desired tax benefits along with expected investment returns and liquidity.
If you expect to have large net realized capital gains in 2019 and would like to explore QOF options, please contact one of our experienced tax professionals. We’d be delighted to assist you.