Opportunity Zone Investing: Real Estate Tax Benefits

About Opportunity Zone Investing

Opportunity Zone tax legislation is part of a government program aimed at driving economic growth in underdeveloped areas. Investors are encouraged to put money into these designated zones by receiving special tax benefits.

Investing in Opportunity Zones isn’t just about financial growth; it’s about transforming distressed areas across the United States. Created under the Tax Cuts and Jobs Act of 2017, these zones are designed to stimulate economic progress and job creation in low-income communities. With thousands of Qualified Opportunity Zones spread across all 50 states, the District of Columbia, and U.S. territories, investors can reap significant tax benefits while contributing to meaningful change.

Looking to Defer Capital Gains? Qualified Opportunity Funds Can Benefit Investors

Investing capital gain income, including Code Section 1231 gains, into a Qualified Opportunity Fund (QOF) offers a strategic way to permanently exclude gains from taxation. This includes gains realized from future sales of investments and any related depreciation that might otherwise be subject to recapture (more on this below). The key? The sale must not occur within ten years of the investment in the applicable QOF.

But how does this work in practice? Capital gains tax can often be deferred by investing in a QOF within 180 days of selling the asset, and sometimes even longer under specific conditions. These deferred capital gains remain untaxed by the IRS until the investor sells or exchanges the QOF interest or until December 31, 2026, whichever comes first.

In short, the Opportunity Zone program offers investors that pay US taxes (individuals, partnerships, corporations, foreign investors) certain tax benefits for rolling over their realized capital gains into a Qualified Opportunity Fund (QOF).

What is a Qualified Opportunity Zone Fund? (QOF)

It’s crucial to understand that a QOF is essentially an investment vehicle designed for investing in QOZ property. The QOF investment vehicle that files either a partnership or corporate federal income tax return and is organized for the purpose of investing in QOZ property. Most commonly these are LLC’s and that be a single member LLC or multi-member LLC (partnership).

Policymakers intentionally made it easy to establish a QOF. There is no application process, instead, filing entities simply elect QOF status with in filing their tax returns (Form 8996) and self-certify that they hold at least 90% of their assets in qualified investments.

Once a QOF is setup, you’ll need to get your capital contributed into it, you should remember that you generally have 180 days to invest an eligible gain into your QOF. This period starts from the date the gain would be recognized for income tax purposes if you didn’t elect to defer its recognition. If your gain comes through an entity issuing a K-1, you have three different methods but can only choose ONE when calculating this 180-day window.

Starting PointDurationOutcome
Gain Occurrence Date180 DaysInvestment Deadline
Entity Tax Calendar Year End180 DaysInvestment Deadline
Entity K-1 Due Date180 DaysInvestment Deadline

Analyzing potential risks associated with each property within a QOZ also forms part of your overall strategy as it helps shape informed decisions. So whether you’re planning on establishing a single or multi-member LLC as your QOF, always ensure you’re knowledgeable about real estate tax legislations laws governing these funds.

A QOF has compliance requirements to keep tax benefits. Failing to satisfy these requirements at any point could result in penalties ranging from a nominal interest charge at the low end to a complete loss of the exclusion from tax on the capital gain resulting from the sale.

What is a Captive Quality Opportunity Fund?

A Captive QOF is one that is formed, funded, and managed by the investor. Managing a Captive QOF allows you to directly control the investment and compliance, reducing associated risks. The fund structure can be customized according to your investment criteria, providing flexibility in choosing Opportunity Zone real estate or multiple Qualified Opportunity Zone Businesses (QOZBs).

Risk management is integral in this scenario. As part of your due diligence process, you need to ensure regulatory compliance at all times as non-compliance can result in loss of tax benefits or even penalties. Therefore, it’s crucial that every transaction aligns with the Opportunity Zone legislation requirements.

One key advantage of a Captive QOF is the ability to reinvest cashflow and refinancing proceeds into additional Qualified Opportunity Zone properties. This means a Captive QOF can invest in Opportunity Zone real estate properties directly and/or into multiple Qualified Opportunity Zone Business (QOZB) from third-party funds managed by general partners. This strategy maximizes your tax benefits by keeping the money within the QOF rather than having it sent back personally, hence remaining tax-advantaged.

Captive Quality Opportunity Fund: Key Consideration

The Opportunity Zone tax legislation basically requires Real Estate deals to be development or heavy value-add. These deals naturally set up for a cash-out refinance at some point in year 2-4. If you invest through General Partner QOF then the money will likely be sent back to you personally and any potential Opportunity Zone benefits (except the 10-year step-up) are lost.

If you invest through Captive QOF into a general partner’s QOZB then the money will be sent back to your QOF and remain tax advantaged. Why is there a focus on growing the captive QOF? If you hold the QOF for 10 or more years then you get to step up the tax basis of the property assets to fair market value. Even the new properties acquired in year 2-9.Using refinance, sale, and cashflow proceeds to get your QOF invested in more QOZB deals is amplifying the tax benefits.

Key Tax Benefit: Step-up In Asset Tax Basis & Depreciation

When you’re dealing with asset tax basis and depreciation, it’s vital to understand that after holding a QOZB for at least 10 years, you can step up your tax basis to the fair market value of the property. This Basis Increase is a significant benefit as it reduces potential capital gains when you decide to sell. This is not the only benefit though. This also allows you to avoid tax depreciation recapture from the tax depreciation taken during the holding period (even if bonus depreciation was originally taken).

You’ve got to remember that depreciation deductions often lead to recapture upon sale but not if your tax basis is stepped-up to fair market value.

Therefore, taking this a step further, by using a cost segregation study to separately allocate property by types of the real property into – 5-year, 7-year, 15-year and electing to take bonus depreciation on those property, there are scenarios where you end up with depreciation deductions significantly more valuable than your original OZ investment.

To add a nugget, if you or your spouse qualify to the real estate professional status (REPS) designation, you can potentially offset accelerated losses generated from bonus depreciation with other sources of ordinary income (like W-2 or other business income).

Even for taxpayers who do not qualify for the REPS designation, the depreciation write offs become suspended losses and when property is sold then taxable gain it will likely be ZERO due to the step-up in tax basis on year 10.  These suspended losses could become NOLs and be available to offset other ordinary income.

Accelerated bonus depreciation benefits no longer an interest free loan from the IRS, they act much more like a tax credit in the Opportunity Zone structure.

Opportunity Zone Investing State Taxes

Not all States conform to the tax benefits of Opportunity Zone investing, others have set their own rules when it comes to Federal conformity.

States that Conform but have specific rules:
States like Arkansas and Hawaii align with federal rules on opportunity zone investments (QOF) within their borders. This alignment can create confusion, as some funds may operate across multiple states.

State-Specific Regulations on QOZ Tax for Corporations and Individuals:
Pennsylvania adheres to QOZ tax regulations for individual taxpayers but excludes corporations. Conversely, Massachusetts permits exemptions and deferrals for corporate taxpayers but not for individuals.

Non-Conformity States:
Four States do not conform to the tax benefits of Opportunity Zones – . California, Washington, Mississippi, and North Carolina stand apart, not conforming to federal provisions on capital gains from QOZ projects. Consequently, residents in these states are subject to state income tax on such capital gains.

Frequently Asked Questions (FAQS)

What is an opportunity zone in real estate?

An opportunity zone in real estate is a designated area where investments, such as in Qualified Opportunity Zone Funds (QOF) or Qualified Opportunity Zone Businesses (QOZB), are encouraged through tax incentives. By investing in these zones, you can defer or reduce capital gains taxes and enjoy benefits like stepping up your tax basis to the property's fair market value after holding for 10 years. It offers unique tax benefits for investors and is part of an overall strategy to boost economic growth in specific regions.

How do I start a Qualified Opportunity Zone Fund (QOF)?

Starting a QOF is easy. You can form it as a single or multi-member LLC and simply file a specific tax form (Form 8996) with your federal income tax return. Make sure 90% of the fund's assets are in qualified investments.

When do I need to invest in a QOF, and what are the tax benefits?

You usually have 180 days from when you gain a profit to invest in a QOF. If you follow the rules, you can delay paying tax on those gains until April 2027. This can increase the money you make from your investment.

What is a Captive QOF?

A Captive QOF is a fund that you form, fund, and manage yourself. It lets you directly control the investment and its compliance with tax rules, reducing risks. You can customize the fund based on your investment criteria and choose to invest in specific Opportunity Zone real estate or businesses. This gives you more flexibility and control over your investment

How can investing through a Captive QOF maximize my tax benefits?

With a Captive QOF, you can reinvest cashflow and money from refinancing into more Qualified Opportunity Zone properties or businesses. This keeps the money within the QOF and tax-advantaged, rather than having it sent back to you personally. If you hold the QOF for 10 or more years, you also get additional tax benefits. Investing through a Captive QOF can amplify these tax benefits, making it an attractive strategy for many investors.

What happens to my taxes if I hold a QOZB for at least 10 years?

If you hold a QOZB (Qualified Opportunity Zone Business) for at least 10 years, you can increase your tax basis to the property's fair market value. This reduces potential capital gains taxes when you sell and lets you avoid taxes on depreciation taken during the holding period. It's like a tax credit in the Opportunity Zone structure.

Disclaimer: For further information or guidance you should contact an experienced CPA or practitioner who is familiar with all of the above tax legislation and applicabilityAny information or articles presented on this website is for educational and informational purposes. The opinions stated on this website represent my own and not the opinions of any other person or organization. No information contained on this website is to be interpreted as financial, tax, investment, and or any other form of advice.

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