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Several years after opportunity zone investments were incentivized by the federal government, new opportunities to invest in these areas to reduce current and future tax liability continue to arise.
The benefit of doing so becomes a bit smaller with each passing year as the end date for tax deferral remains the same. Yet, there are still reasons to consider making such an investment, particularly if you’ve realized a sizeable capital gain.
Today’s guest from Fiona Smith post explores the pros and cons of these investments, and we consider how pending legislation could impact opportunity investments for certain taxpayers if passed.
Fiona Smith is the Founder of The Millennial Money Woman. She’s been featured on Forbes, was a speaker at the national FinCon 2021 conference, and she’s a co-founder of a local non-profit charity, promoting financial literacy with underprivileged minorities. Fiona earned her Master of Science degree in Personal Financial Planning and is a self-proclaimed finance ninja. Fiona’s passion is helping others take control of their money to build a better future. You can find her on Twitter: @The_MMW or sign up for her newsletter.
Time is slowly running out.
If you’re an investor who may be facing a capital gains tax liability but doesn’t want to pay the taxes today, keep reading this article to see how you can not only defer your gains through 2026 but also how you could potentially decrease your tax liability.
The key here is to keep yourself informed and to act fast because the clock is ticking.
Congress already has several new tax proposals lined up that could impact how much high-income earners would pay in the future.
One savvy way to help defer your tax liability on capital gains and potentially build passive income streams could be by investing in a qualified opportunity zone.
What is a Qualified Opportunity Zone?
A qualified opportunity zone (also known as a QOZ) is a program that was established under the Tax Cuts and Jobs Act of 2017 with the idea of providing a tax incentive for real estate investors to invest their money in low-income areas.
About 8,700 zones have been designated for investors.
What was the original goal of a QOZ?
To help infuse low-income communities with money from investors to increase the value of poverty-stricken and depressed communities.
What are Qualified Opportunity Funds?
A Qualified Opportunity Fund, or QOF, is typically a corporation or other business entity that invests in a QOZ. Because a QOF files the IRS Form 8996, it receives preferential tax treatment if investors buy and hold for 5 or more years.
These funds can use the investors’ money for a variety of reasons, including but not limited to:
- Converting vacant homes for single-family rental units
- Improving abandoned lots for commercial or residential use
By the end of 2020, over $15 billion have poured into Qualified Opportunity Funds (also known as QOFs), which is easily the simplest way for investors to take advantage of the QOZ program (multiple qualified opportunity zone properties are purchased by a qualified opportunity fund).
What Tax Incentives are Offered through a Qualified Opportunity Zone?
Qualified Opportunity Zones could be excellent alternative investments for real estate investors who have qualified capital gains from either stock sales, previous real estate sales, business sales, or any other investment-related sales that happened before January 1, 2027.
After making a sale and realizing a capital gain, investors are given up to a maximum of 180 days to complete IRS forms 8949 and 8997 to take advantage of the tax deferral incentives offered by QOZs.
Investing in qualified opportunity funds, investors could receive the following potential tax-advantaged treatment:
- Defer any tax liability on capital gains until December 31, 2026
Decrease their cost basis by up to 15% of the initial capital gain (if held for 7 years or longer)This opportunity has since expired.- If holding the investment property for more than 10 years, investors could also eliminate tax liability on capital gains from QOZ investments
To summarize, if an investor has a taxable gain and doesn’t want to pay the tax liability today, then they could invest their money (following the IRS parameters) into a QOF to not only defer their taxable gain through 2026 but to also reduce their taxable gains, assuming they follow all guidelines.
Opportunity Zones: Now is the Time to Consider Investing
If investors with gains were to consider investing in a QOF today, then they could still:
- Defer their capital gains until December 31, 2026
- Remove any tax liability on capital gains realized from a QOZ if holding for 10+ years
While investing in qualified opportunity zones is a consideration that’s now more important than ever before, it’s also critical to consider the pros and cons that go along with investing in QOZs.
Opportunity Zones: The Pros and Cons
As with all investments, there are pros and cons that you must consider before investing your hard-earned cash.
Some QOZ pros include:
- Tax breaks
- Tax deferral
- Improves low-income communities
Some QOZ cons include:
- Illiquid investment (minimum of 5 years)
- Many investment options with little oversight
- Risky, since you’re investing in an area deemed to be in need of outside investment
- [PoF: Deferral may not be so beneficial if your future capital gains rates will be higher]
It should also be noted that in many cases, you must be considered an accredited investor to invest in QOFs.
Accredited investors could be if you:
- Earn $200,000 (single) or earn $300,000 (married) for the last 2 years and expect to earn roughly the same again for this year
- Have a net worth of $1 million, excluding your primary residence (regardless if you’re single or married)
At the end of the day, it’s important to weigh both the pros and the cons and determine if one makes more sense over the other, given your personal financial situation.
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Closing Thoughts
As you contemplate your potential options surrounding decreasing and deferring your capital gains tax liability, just make sure that whichever route you choose, your solution also makes financial sense.
Keep in mind that while many benefits come with opportunity zones, QOZs are still real estate investments in nature.
That means your money will likely be illiquid for extended periods and you should also consider the modern-day inflationary cost of lumber, construction goods, and even labor, just to name 2 key drawbacks.
Since it’s virtually guaranteed that capital gains tax rates will increase for some by January 1, 2022, it’s critical to decide on your future with qualified opportunity funds today before the December 31, 2021 deadline approaches.
If you want to understand more about QOZs, consider consulting your accountant and/or your financial advisor to provide you with a more customized approach to investing in opportunity zones.
[PoF: The current proposal for capital gains tax changes is an additional 10% at the federal level for single filers earning $400,000 or more or married couples filing jointly earning $450,000. Most taxpayers will still pay 15% under this proposal, but the top bracket increases from 20% to 25%. If your earnings are in this higher range, you’re also paying the 3.8% NIIT tax, and most people will also owe state income tax with the obvious exception of those who live in select states that don’t levy one.
If you think your income will be $400,000 or more in 5 to 6 years, the benefit of the tax deferral may be counteracted by a higher capital gains tax rate on those deferred gains. I think this is an important consideration when weighing whether or not it makes sense to participate in a QOZ investment.
Where can you find them? A quick Google search will pull some up. Here are 3 options from real estate investment companies that we’ve partnered with. I have invested with each of these companies, but not in qualified opportunity zone investments.
- Crowdstreet Opportunity Zone Fund II
- Origin Investments QOZ Fund II
- EquityMultiple (More info on Opportunity Zones)
Note that Crowdstreet also offers an Opportunistic Fund, which is not to be confused with an Opportunity ZONE fund. It’s confusing, I know; the former has significantly higher projected returns but will not be investing in Opportunity Zones.]
Have you made an investment in an opportunity zone? What factored into your decision?
3 thoughts on “Opportunity Zones for Real Estate Investors: The Good, The Bad, The Ugly”
Thank you so much for this timely article! I’ve been interested in opportunity zones with the spirit of the law. I’d love to do well by doing good, but even if my returns are more modest and only offset by the taxes I’d be willing to consider investing rather than just donating to some of these areas. Im thinking of the POF brewery investment that supported a local business, but done a little differently. Also this article was very interesting The Rich Have Found Another Way to Pay Less Tax https://nyti.ms/3FxubHI
Remember not to let the tax tail wag the investment decision. QOZs are risky investments. They were set up to encourage investments into areas where people have not liked to invest as they find these areas higher risk for their investment dollars. If the investment does not perform or loses money, the tax savings you will get from QOZ may not be worth it. Just something to consider when looking into QOZ as many just see tax savings and run toward that investment. A thorough analysis of the investment opportunity is still very much needed prior to making a decision on any QOZ.
We sold our home this year and had a significant gain. We looked into QOZ as an potential option after another MD told me about it and suggested i look into it as she had “done very well” with her investment. It was the classic “water cooler investment” chat that you always need to be wary of. This time it was QOZ but it could have easily been Bitcoin, GameStop, etc.
Anyway, i looked into it and it isn’t quite as simple as it seems. First of all, as mentioned in m this post, the QOZ expires in 5 years. It isn’t clear if Congress will extend the deadline further into the future. As such, there isn’t certainty that you will get the potential tax benefits of holding the investment for the 7 or 10 year mark (and this is one of the big selling points of QOZ). They very well may extend the expiration, but that may not happen- your guess is as good as mine. Secondly, many of these funds have significant costs and fees associated with them. You need to figure out if the return on your investment can beat a typical low cost fund that we all are ideally using for our portfolio. Lastly, as you already describe, the capital gains rate in almost certainly going up, so the benefit may not be there in the end.
This post has all the warning signs that an investor needs to be aware of. “Act now!” “Time running out!” “You may miss this opportunity if you wait”. While QOZ may be the right investment for some situations, be cautious and perform your due diligence before jumping in.
Just my 2 cents…