Frequently Asked Questions about Opportunity Funds
Answers to common questions about Opportunity Zones
What Makes an IRS Opportunity Zone?
Why they can be a boon to real estate investors
Learn about how you can reap the rewards of investing in the most tax-advantaged asset class in America.
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Opportunity zones (OZs) were created as a part of the Tax Cuts and Jobs Act (TCJA) of 2017 as a federal stimulus to support distressed communities throughout the United States. The program’s goal is to create jobs and drive economic growth in some of the country’s poorest areas by incentivizing investors to redirect capital there, rewarding them with a variety of tax benefits if certain conditions are met.
There has been a lot of discussion about opportunity zones and the potential tax benefits they represent. This comprehensive guide will help to address the following questions and topics:
- What is an opportunity zone?
- How to invest in an opportunity zone?
- What tax incentives are there for investing in an opportunity zone?
- How do opportunity zone tax benefits work?
- What risks are there when investing in opportunity zones?
- What qualifies as an opportunity zone?
- How to find a opportunity zones?
- How to form an opportunity zones fund?
- Recently proposed changes to opportunity zones
- Qualified Opportunity Zones: In Summary
What is an opportunity zone?
Opportunity zones are designated geographic areas that have been identified as low-income census tracts. These census tracts were nominated by governors and certified by the U.S. Department of the Treasury. To be eligible, they needed to have 1) a median family income of less than 80% of the surrounding area or 2) an average poverty rate of 20% or more.
There are currently 8,700 opportunity zones in both rural and urban areas throughout the country, with OZs in every state and territory. Over 35 million people reside in the designated OZs. As a whole, opportunity zones have an average poverty rate of 29% and troubled real estate markets. In the past decade they've seen a sluggish overall economic progress and a decline in population.
While these areas are some of the most underserved communities of the country, there is an opportunity for revitalization. The zones currently have 379 colleges or universities, 479 airports, 475 solar energy installations, 127 wind farms, 15 battery plants in the zones, 24 million jobs, and 1.6 million in businesses. The influx of capital is an opportunity to help established businesses grow and expand while also bringing new measures for economic growth.
How to invest in an opportunity zone?
Participating in an opportunity zone and the preferential tax treatment they offer is done by placing qualified capital gains in an Opportunity Fund. Opportunity Funds are pooled investment funds that follows specific requirements to gain this designation and there are several opportunity funds to choose between.
Eligible capital gains can be realized from the sale of stocks, bonds, private business, or real estate. Accredited investors can participate in the preferential tax treatment opportunity zones offer by rolling their current capital gains into a qualified OF within 180 days from the sale of the asset in addition to filing IRS form 8949 with their taxes. Non qualified capital gains funds can also be invested in an OF, but that money will not be eligible for the same tax incentives.
A qualified opportunity zone fund is a private fund structured as a corporation or partnership that invests more than 90% of its capital into an opportunity zone. A recent ruling stated that a fund’s failure to meet the 90% asset test would not disqualify them from being classified as an opportunity fund, but may result in a penalty.
The fund can invest in any qualified asset, which may be real property, equipment, or a business where 50% or more of their income is derived from an opportunity zone. If property is purchased, the OF needs to make “substantial improvements” to the property within the first 30 months. OFs are subject to review at six-month and year-end intervals to ensure compliance with regulations and requirements.
The number of OFs is consistently growing, which provides accredited investors interested in participating in this tax shelter with a number of options. Novocgradac created a list of the current opportunity funds available to invest in with their targeted geographic area and investment focus. Every opportunity fund works differently, targeting various asset types in distinct opportunity zones. Similarly to a crowdfunding investment, the opportunity fund should provide an offering memorandum (OM) which outlines the investment opportunity, market summary of that specific opportunity zone, economic outlook, and projected performance.
However, it’s essential the investor verify the feasibility of the investment and feels comfortable with the structuring of the fund and its holdings. It’s also important to see what other assets the fund has managed or completed. While this is no guarantee that the opportunity fund will succeed, it does show that the fund has a track record and experience in the business.
What tax incentives are there for investing in an opportunity zone?
Opportunity zones offer the following preferential tax treatment on capital gains for investors participating in qualified Opportunity Funds (OF) including tax deferral, a step-up basis for capital gains, and capital gains exclusion. Here is how each benefit applies:
- Tax deferral: Investors can defer capital gains taxes by reinvesting capital gains into a qualified opportunity fund. The deferral gain must be realized before the opportunity fund investment is sold, exchanged, or by Dec. 31, 2026.
- Step-up basis for capital gains: If the opportunity fund holds the investment over a period of five years, there is a 10% elimination of the original deferred gain. If the investment is held for more than seven years, that 10% becomes 15%. For example, if an accredited investor rolls a capital gain of $100,000 from a previous investment into an opportunity fund, only $90,000 of the original investment would be subject to capital gains tax after five years, and only $85,000 if the investment is held after seven years.
- Capital gains exclusion: If the opportunity fund sustains the investment over a period of 10 years, the capital gains made from the opportunity fund itself are permanently excluded from capital gains taxation. This is by far the most significant benefit and can meaningfully enhance the total return to investors in these projects who are patient enough to hold for this length of time. Frequently Asked Questions about Opportunity Funds
How do opportunity zone tax benefits work?
To appreciate the tax benefits of investing in opportunity zones, it’s helpful to visualize what an investment in an opportunity fund (OF) may look like.
Several factors affect how much you benefit from the tax law, including:
- the amount of funds invested,
- the length of investment,
- your current filing status,
- your income, and
- the overall return received from the OF.
The example below is meant to illustrate how an investment in an opportunity fund could work.
Imagine you rolled over $50,000 from a qualified capital gain into an opportunity zone fund (OZF) in November of 2019. You're married and file jointly, making over $250,000 a year in joint taxable income. This places you at a capital gains tax rate of 20% with an additional 3.8% to net investment income tax.
The opportunity fund you invested in provides a 9% return over the life of the investment and is held for 10 years. This means you can defer the tax payment on your original capital gains until 2029 in addition to receiving a reduction of 15% on the original basis.
By year 10, you're only required to pay taxes on $42,500 of your original capital gains and pay no tax on the capital gains made from the OZF over the 10-year investment period. In this example, utilizing the tax incentives offered by investing in an OZF would lead to a 60.91% additional return, or $30,456 more than a standard non-opportunity zone investment would.
The longer an investment is held in an OZF, the greater the tax incentives and additional investment return. Opportunity zone funds work in different ways, so it’s important to identify a fund that appeals to you within the 180-day rollover period and conduct your due diligence on the fund. We suggest researching the fund manager’s experience, reviewing past performance in other sectors, and thoroughly analyzing the opportunity zone and asset class the fund is focused on.
What risks are there when investing in opportunity zones?
As with any investment, there are risks with investing in opportunity zones. The largest is the viability of the investment in that zone. Just because there are tax incentives to place money in certain areas, it doesn’t mean every investment will be profitable. The location and type of investment matters. Look for a fund that has diversified assets across different opportunity zones.
Additionally, for investors to take full advantage of the tax incentives offered with opportunity zones, they need to roll a portion of their capital gains into an opportunity fund. This can reduce the diversification of the investor’s portfolio during this period, which can increase exposure to risk. If you are interested in investing in opportunity zones, continue learning about opportunity zones, the risks involved, and start the search for potential opportunity funds to work with. Make sure the opportunity fund is following the required rules and guidelines in order to keep the designation of a qualified OF and be able to take full advantage of the tax opportunities available as one.
This economic development tool and tax haven holds massive potential for those involved. If opportunity zones work as intended, they will offer tax incentives to investors shifting capital into undercapitalized communities of the country. If you are interested in investing in an opportunity zone, it’s important to identify a fund to invest in sooner rather than later to take full advantage of the tax incentives available. There are high hopes for a positive impact in areas of need as this investment opportunity continues to unfold over the next decade.
What qualifies as an Opportunity Zone?
In order to be deemed an Opportunity Zones, an area must have been nominated for that designation by their state and that nomination has been certified by the IRS. Additionally, for real estate developments to qualify for opportunity fund financing, the investment must result in the properties being vastly improved, by the government’s terms.
Opportunity Zones were first rolled out in April 2018 and included 18 states. Since that time the program has expanded and covers all 50 states.
According to the Treasury Department, close to 35 million Americans live in communities designated as Opportunity Zones. Based on data from the 2011-2015 American Community Survey, the designated census tracts had an average poverty rate of more than 32%, almost double the 17% rate for the average U.S. census tract.
Moreover, these Opportunity Zones are also twice as likely as other U.S. communities to be located within a county that has suffered from persistent poverty. This means the county has experienced a poverty rate of at least 20% for 30 years.
How to find an Opportunity Zone
Opportunity Zones are shining the spotlight on parts of the country that have been typically passed over when it comes to investing. Although it may seem like a daunting task, finding an Opportunity Zones, especially through a qualified Opportunity Zones map, is easier than you think.
Take a peek at the list of designated qualified Opportunity Zones in IRS Notices 2018-48 (PDF). The list is organized in alphabetical order by state and includes all of the population census tracts that the Treasury Secretary designated as Opportunity Zones.
In order to find out if an investment is in an Opportunity Zones, you can search by address online using the Census Bureau’s Geocoder tool to determine the census tract in which a specific address lies. You can also then use the Opportunity Zone mapping system or the list of designated Qualified Opportunity Zones to determine the status of that census tract.
To stay abreast of updates to Opportunity Zones, one public policy group that played a role in creating the program, the Economic Innovation Group, created a resource page that links to an interactive map and state-by-state Opportunity Zones updates. On this site you can explore an individual state’s Opportunity Zones program, such as how many areas received the designation as well as the population and employment statistics in each zone.
The EIG has estimated that more than $6 trillion of potential capital gains are eligible for the program.
Smart Growth America’s LOCUS published a National Opportunity Zone Ranking Report. The report noted that it ranks each of the designated Zones based on its Smart Growth Potential (SGP) as well as its Social Equity + Vulnerability Index score (SE_SVI). It includes a smart growth potential filter for investors to identify which Opportunity Zones should be prioritized for investment from a triple-bottom-line perspective that can deliver positive economic, environmental, and social returns.
The group created the report to give local policymakers and community groups a plan to manage and ensure equitable, inclusive development in Opportunity Zones.
The Urban Institute also offers a state-by-state analysis of Opportunity Zones. This includes homeownership rates, ethnicity, and education levels.
How to form an Opportunity Zone fund
The IRS describes an Opportunity Zones fund as an investment vehicle that files either a partnership or corporation federal income tax return and is organized for the purpose of investing in qualified Opportunity Zones property. You can get and file Form 8896, from the IRS
and create a qualified opportunity fund.
It can be structured as a partnership or corporation as long as the purpose is to invest in one of the Opportunity Zones’ census tracts, through real estate or in businesses through equity. But remember, the fund must hold the bulk -- 90% -- of its assets in an Opportunity Zones area.
In contrast to existing programs, opportunity funds can self-certify without needing a government agency to approve the fund. In this scenario, it’s the private market fund managers that are responsible for managing the opportunity funds instead of investors or government agencies.
The great thing is that there is no limit to the number of opportunity funds that can be created or dollars that can be invested into it. This gives it the potential to become one of the largest programs aimed at developing low-income communities.
Recently proposed changes to Opportunity Zones
There was some clarification needed surrounding Opportunity Zones, so government officials relaxed some of the requirements that looked at hours, wages, or tangible property. For example, if at least 70 percent of the tangible property owned or leased by a trade or business is qualified Opportunity Zones property it meets the requirement.
In April, the IRS and Treasury issued its second round of regulations for qualified Opportunity Zones. With regulations evolving, it’s easy to get mixed up, which can result in lost funds.
This proposed regulation was related to gains that may be deferred as a result of a taxpayer's investment in an opportunity fund, special rules for an investment in the fund held for at least 10 years, and updates to portions of previously proposed regulations under section 1400Z-2 to address various issues.
The latest proposed rules should help promote jobs, and paves the way for investments in other businesses operating within the Opportunity Zones aside from real estate. The businesses can qualify for the 50% gross income requirement if half of the company’s employee hours or wages are sourced in the zone.
The new regulations now spell out exactly how businesses can meet the 50% threshold with looser requirements that take into consideration businesses that operate witihin Opportunity Zones but get a large amount of business from other places. They can alo satisfy the 50% test if at least 50% of the total amount the company pays for services performed goes toward services performed in the Opportunity Zones and the company’s tangible property and management or operational functions performed in the Opportunity Zones are necessary to generate 50% of its gross income.
Additionally, this recent set of proposed rules clarifies that a fund investing at least 90% of its assets in Opportunity Zones properties, won’t lose its tax-advantaged status if it sells qualified property, stock, or partnership interests in the fund. However, there’s a catch. This is true just as long as it reinvests the proceeds in another qualified property within 12 months.
Qualified Opportunity Zones: In summary
Opportunity Zones can be a great way to invest in real estate while helping to improve communities in need of new development. While the tax benefits may lure you to invest in uncharted territories, it’s important to make sure you completely understand the intricate details of Opportunity Zones investing.
Take into consideration that you must hold the property for a minimum of 10 years to receive a full tax-exempt status on your investment. This means the real estate market has the potential to go up or down during that time.
Setting up an Opportunity Zones fund is one of the first steps in investing in Opportunity Zones. The necessary form can be found on the IRS’s website. It’s important to remember that this fund has to have 90% of its assets in an Opportunity Zones.
Do your research before investing and find out which types of communities are most aligned with your investment goal. While doing both is a win-win, some investors strictly look to enhance their bottom line while others are solely focused on improving the community and thus take on more of a risk.
For more information about Opportunity Zone Funds please check out our Opportunity Zone FAQ here