Opportunity Zone Funds: Definition and How to Invest
Ashley Chorpenning
Here's everything you need to know about opportunity zone funds.
Opportunity Zone Funds are investment vehicles that provide tax incentives for investors. Partnerships or corporations can establish Opportunity Zone Funds and then invest in a property located within a Qualified Opportunity Zone. These investment vehicles are designed to increase economic development and job creation in distressed communities, as well as offer tax benefits to investors. Read on to discover what investors should know about Opportunity Zone Funds and if this investment selection is right for you.
What Are Qualified Opportunity Zones?
The purpose of a Qualified Opportunity Zone is to revive a community that is facing economic stress. The 2017’s Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to offer tax benefits to private investors who invest in these communities. Since the passing of the law, Opportunity Zones were identified in all 50 states as well as the District of Columbia and five territories and commonwealths including American Samoa, Guam, Northern Mariana Islands, Puerto Rico and the U.S. Virgin Islands.
More than 8,700 Qualified Opportunity Zones have been designated across the U.S. According to the Urban Institute, the majority of these zones have lower household incomes, higher poverty rates and higher unemployment rates than those of other communities.
Qualified Opportunity Zone Funds Explained
Here's everything you need to know about opportunity zone funds.
A Qualified Opportunity Zone Fund is an investment vehicle. Corporations and partnerships must organize each fund. Investors can do this by filing Form 8996. The intention behind all Qualified Opportunity Zone Funds is to invest in and grow the Qualified Opportunity Zone. Additionally, this fund must hold at least 90% of its assets in Qualified Opportunity Zone properties.
Like other investments, these funds can increase and decrease in value during the holding period. There’s also a possibility that the investment can yield a cash flow. However, since the purpose of the investment is to help communities gain traction, all proceeds should be reinvested to help increase growth in these communities. But, once property improvements are done, investors can sell the property to a third party for cash flow.
Currently, it’s challenging to assess the level of risk this investment yields. Because the IRS and U.S. Treasury are still figuring out how these funds will perform over time, it’s hard to establish a risk level. Some potential risks of this investment may include liquidly risk, market loss and business risk.
How Does the Qualified Opportunity Zone Program Work?
Rather than using taxpayer dollars to stimulate economic growth in these communities, the government decided to use private investments. To encourage private participation, individuals who invest in Qualified Opportunities Zones are eligible for tax incentives.
To capitalize on this program, a taxpayer must invest their proceeds from their sale of an asset (realized gain or capital gain) into a Qualified Opportunity Zone Fund. This must happen within 180 days of the sale. However, while a taxpayer may invest the returns of the sale of an asset, as well as the potential gains, the tax incentive only applies to the capital gains.
Also noteworthy, investors can use the proceeds from any appreciated asset. It’s not a requirement to invest with a like-kind asset to defer potential gains.
Tax Incentives for Investors
Qualified Opportunity Zone Funds provide tax benefits to investors in three various ways.
Tax Deferral Through 2026
For investors who want to defer the tax on their capital gains, they can invest in an Opportunity Zone Fund. This must happen within 180 days of the sale of the asset or security. The IRS doesn’t recognize any gain in an Opportunity Zone Fund until December 31, 2026, or until the investor sells or exchanges the interest.
For example, if a taxpayer sells an asset for $5 million, which then results in a $5 million capital gain, the investors can invest the proceeds into a Qualified Opportunity Zone Fund. As long as this happens within 180 days of the sale, the investor can avoid capital gains taxation. This allows the investor to keep the $1 million instead of facing possible taxation on the gain (assuming the 2019 IRS rate of 20%). This could potentially provide a substantial return for the investor through the life of the investment.
Step-Up Basis of Deferred Gains
Investors who decide to invest in Qualified Opportunity Zone Funds can receive a 10% step-up basis after five years of investing in the fund before 2026. Additionally, investors can receive an extra 5% step-up basis after seven years before 2026. To maximize the step-up basis, investors must invest by December 31, 2019. Also, they must keep assets in the fund for at least seven years to receive the total 15% step-up basis.
If we use the example above, after five years of investing in the fund, the taxpayer may be given a $500,000 basis. This is 10% of the original $5 million capital gain deferred. If the investment is held in the fund for seven years, the investor may be given another $250,000 of basis in the fund. This is 5% of the original capital gain. Together, this is a total of $750,000, or 15% of the original capital gain.
No Taxation on Appreciation
Here's everything you need to know about opportunity zone funds.
For investors that keep their investment in the fund for at least 10 years, the property will then be equal to fair market value from the date of sale or exchange of the asset. Keep in mind, while this can potentially lower the cost basis, it doesn’t eliminate the gain recognized on December 31, 2026.
For example, let’s say a taxpayer makes a $5 million investment in a Qualified Opportunity Zone Fund in 2019. If the investor sells the investment in 2029 for $10 million, the $5 million in appreciation is free of taxation. However, the investor will have to pay income taxes since the fund was held beyond 2026. These taxes will correspond with the sale of the investment.
The Bottom Line
Opportunity Zone Funds may not fit every investment portfolio. If you’re about to sell an asset and want to delay capital gains taxation, Opportunity Zone Funds are worth exploring. Consider all types of investments before determining an asset allocation that aligns with your financial goals.
Investing Tips
A financial advisor can help you put together a plan that will utilize several of the above types of investments. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your stocks with a capital gains tax calculator.
