My previous post covered the incredible tax benefits of investing in an opportunity zone. If you want a technical summary on the nuts and bolts of this tax break, which was included as part of the Tax Cuts and Jobs Act, you can click here to read it. This post will focus more on how to invest in qualified opportunity funds (QOF), which are the partnership or corporations formed to invest in opportunity zones, rather than the benefits of doing so. After all, what good is the information if you don’t know how to take the next step to take to invest?
A list of qualified opportunity zones (QOZ) can be found here.
If you sell an asset that triggers capital gain, you can invest that capital gain into a QOF and defer the capital gain. If you hold your interest in the QOF for five years, your basis will increase by 10 percent of your original capital gain invested (reducing your capital gain). If you hold the investment for seven years, your basis will increase another 5 percent (reducing your capital gain). If you hold your investment for 10 years, then your entire new basis (original investment with a 15 percent basis increase) will become taxable once you sell the QOF or on December 31, 2026, whichever is earlier. However, any appreciation on your investment in the QOF is 100% tax free! Simply put, you are going to pay the capital gains tax on the new adjusted basis on your 2026 tax return but you could potentially eliminate a huge gain if you make a good initial investment.
You sell stock for $1 million that had a basis of $200,000. You invest the $800,000 of capital gain in a QOF which defers the tax payment on the $800,000. You hold the QOF for 10 years and the $800,000 appreciates to $2 million in that 10 years (10 percent annually). The $1.2 million is a completely tax-free gain when you sell, and you’ll pay the capital gains tax on the $680,000 ($800,000 less 15 percent basis increase = $680,000) of basis on your 2026 tax return.
It’s important to note that unlike a 1031 exchange, you have the ability in a QOF to defer any capital gain if you invest in the QOF as opposed to only capital gain from a “like-kind” property in a 1031 exchange.
How to invest in a QOF
First, the funds you use to invest in a QOF must be tax deferred gains. You cannot invest “new capital” into the fund and also take advantage of the tax benefits of the QOF. Congress told us that they enacted this legislation to incentivize investors to invest in low-income areas. Not being able to invest “new capital” seems contrary to their given purpose but… we don’t write the rules. If you invest some tax-deferred gain in the QOF and some “new capital” in the QOF, only the portion of the QOF appreciation attributable to the deferred gain you initially invested will be eliminated.
With just a quick Google search, or a call to your Wells Fargo or Fidelity broker, you can invest in a QOF that has already been set up. That is the quickest and easiest way to get into a QOF. However, if you want to be less passive and have control your own fund and assets, you can do that as well. You can certify your own QOF by filing Form 8996 alongside the relevant entities tax return.
What Qualifies as a QOF?
At least 90 percent of the QOF needs to be invested in qualified opportunity zone (QOZ) property, which includes one of three things: QOZ business property, QOZ stock, or QOZ partnership interest
- QOZ stock: Stock from a QOZ business
- To qualify as a QOZ business, 70 percent of the business-owned or leased property must meet the QOZ business property rules (see below for those rules)
- QOZ partnership interest: Interest in a partnership or corporation in which at least 50% of the entity’s gross income is derived from a business within a QOZ.
- QOZ Business Property: Tangible property used in a trade or business within a designated opportunity zone that is acquired by the QOF after December 31, 2026, and substantially improved.
QOZ Business Property
This is defined directly above, and is the most relevant definition to real estate investors. Simply put, you need to bring new property to the opportunity zone. It’s not good enough to simply acquire an existing property in this zone; at least not for the QOF purposes and the desirable tax benefits.
Practically speaking, you need to build a new building or “substantially improve” an existing building in an QOZ to qualify as a QOF. To substantially improve the tangible property in this case, you need to put as much into the improvements as you did to purchase the property. Land is not taken into account in the “substantially improved” calculation, only the building’s basis. See below for practical examples.
ABC, LLC acquires an apartment complex is purchased in an QOZ in 2018. It’s the only asset ABC, LLC owns. ABC does not make any substantial improvements to the property. In this case, ABC can NOT register as a QOF because they did not substantially improve the property.
ABC, LLC buys an apartment complex for $2 million in an QOZ. Of the purchase price, $500,000 is attributable to land, and the $1.5 million is attributable to the building. ABC puts $1.5 million of renovations into the complex. ABC doubled the buildings basis with the renovations, so it is now considered substantially improved. Since this is the only asset ABC, LLC owns, it holds true that at least 90 percent of the assets are invested in QOZ property. ABC, LLC can self-register as a QOF.
You have 30 months to complete renovations to the property once you purchase it. Make sure you keep clear records of your plans to improve the property along the way.
As it currently stands, the regulations are a bit nebulous when it comes to how to treat raw land in an QOZ. Since the cost of land is not relevant in the “substantially improved” calculation, it’s theoretically feasible to purchase a tract of land in an QOZ, raise a building on that land, and then qualify the land and the building as a QOF regardless of the building’s price. What’s safer to assume is that only the portion of land that you raise the building on is the portion will be included in your basis of the QOF alongside the cost of the building.
These rules are extremely complex, nuanced and new to everyone. I wouldn’t recommend embarking on a journey to create your own QOF without consulting a tax advisor first.
As with any tax planning advice from a professional that is worth their weight, the goal is never to merely save money on your tax bill. The goal is to improve your overall economic position. It is always better to make good, sound investments that will presumably make money and generate tax than it is to make silly investments that lose money but generate no tax. We want to put more money in your pocket, not just put less money in the government’s pocket. Make sure the QOF is actually a good investment.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.