The Basics of Qualified Opportunity Zones
It’s a sad truth for investors: unless you’re buying and selling in a 401(k), IRA, or other tax-sheltered vehicle, capital gains taxes are a simple fact of life. They’re the bitter pill investors swallow when they sell a taxable investment at a gain, and the IRS comes calling for its cut in the form of a tax that can be up to 40.8% — 37% as a potential short-term capital gains tax, plus an additional 3.8% net investment income tax, depending on how long the investment was held and the tax bracket of the investor.
Not known for its generosity of spirit in the best of circumstances, the IRS is particularly stingy when it comes to capital gains taxes. The opportunity to defer the payment of such taxes is rare; the opportunity to eliminate them entirely, even more so.
Qualified Opportunity Zones
Enter the creation of Qualified Opportunity Zones, or QOZs.
Astute students of American politics will recognize the seeds of QOZs in the Empowerment Zones of the 1990s, and the Promise Zones created during the Obama administration, which called upon Congress to cut taxes on hiring and investment in these geographic areas targeted for economic development. But the idea was not fully realized until President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. The TCJA was responsible for the creation of Qualified Opportunity Zones, areas designated in each of the fifty states, the District of Columbia, and five U.S. territories.
The Aim of QOZs
The aim of the law was twofold: to spur economic growth and job creation in parts of the country that can best benefit from growth and economic development while providing tax breaks to the investors who chose to invest in them. The communities were designated as Opportunity Zones by governors of the respective U.S. states and territories, with the subsequent approval of the Treasury Department. Currently, over 8,700 such OZs exist across the country, though investing in a QOZ does not require you to live or work in the area you choose for your investment. A complete map and listing of the Opportunity Zones can be found on the Department of Housing and Urban Development’s website.
QOZs from the Investor’s Standpoint
From the investor’s standpoint, the beauty of the QOZ opportunity lies in the fact that it enables an investment of money that would otherwise be subject to capital gains taxes. Importantly, the capital gain in question can come from the sale of appreciated real estate but is not limited to real estate gains. Whether your appreciated asset was real estate, stocks, bonds, cryptocurrency, an art or coin collection – any realized capital gain is eligible for investment in a QOZ.
Taking the amount of your capital gain and making a timely investment into a qualified OZ investment defers the payment of the tax until the subsequent sale of the investment or December 31, 2026, whichever comes first. But investors can also choose to hold the investment past the 2026 deferral deadline, and they’re well-incentivized to do so. Any investment held for a minimum of ten years will avoid any Federal capital gains tax on the QOZ investment itself, and may also eliminate state capital gains tax, depending on the state in question.
QOZ Options for your Investment Portfolio
The plethora of options available in any state or territory affords investors ample opportunity to diversify their real estate portfolios geographically. The sheer number of different kinds of QOZ investments available (existing or start-up businesses; apartment buildings or multi-family housing; commercial or residential real estate; medical buildings or hotels) offers tremendous diversification within sectors. There are limitations, of course. Golf courses, country clubs, liquor stores, casinos, or massage parlors, for example, cannot be included in a QOZ investment, but the available options far outweigh the exclusions.
As you can imagine, a significant tax break is accompanied by a myriad of rules, regulations, and requirements, and running afoul of any of these will reduce or eliminate the tax breaks in question. This guide will examine all the ins and outs of QOZ investing in great detail. Interested investors should also consider our QOZ Masterclass, which will teach you everything you need to know to take full advantage of what many experts call a “once in a generation” opportunity!
Learn about Daniel Goodwin’s Masterclass on Qualified Opportunity Zones
Infographic: How To Invest In An Opportunity Zone
Click here to download the How To Invest In An Opportunity Zone Infographic, or see below.
Tax Benefits of Investing in Opportunity Zones
Other Benefits of Opportunity Zone Investing
The focus on QOZ investing has, correctly, been primarily on the tremendous, once-in-a-generation tax advantages available to investors who choose to commit to a qualified opportunity fund. Projects across the country have attracted capital from investors of all sizes, from individual retail investors to multibillion-dollar investment banks. The ability to defer capital gains from a current investment until December 2026, and perhaps eliminate such taxes entirely from a new QOZ investment by holding it for at least ten years, is compelling on its own terms.
Nevertheless, the very name of the legislation (the Tax Cuts and Jobs Act of 2017) points to the dual purpose of the establishment of qualified opportunity zones. They are not just tax benefits for investors, but also jobs and vigorous economic renewal for the communities so designated. Indeed, the 8,700+ U.S. Census tracts named as QOZs are mostly areas that have faced historical challenges and hardships attracting attention from businesses and investors alike.
Not just tax advantages
The purpose of the Act was the creation of jobs and long-term economic development, not in the usual places that have little difficulty attracting capital, like New York City or Silicon Valley, but rather in the decaying urban neighborhoods and sparsely populated rural areas that have not been historic magnets for venture capital. Analysis suggests that these opportunity zones are hampered by significantly higher unemployment rates and poverty rates, and lower life expectancies, than the national averages.
The potential for economic growth in neighborhoods that had long since been abandoned by businesses both large and small was an essential reason the TCJA received bipartisan support, and continues to be supported on both sides of the political aisle, a rare enough feat in American politics in 2023. And the overwhelming success of the program thus far has led legislators to seek the extension of QOZ investing past its current 2026 expiration.
No legislation has passed so far, but there is genuine optimism that a two-year extension, at the very least, may find traction in the 118th Congress. Regardless of whether Congress is able to extend the life cycle of QOZ investing, however, the program has already proven to be a demonstrable success, impacting neighborhoods across the country as well as those who have invested in them.
Case Study: Port Covington, Baltimore
The largest city in Maryland and the 30th-largest city in the United States, Baltimore provides an excellent example of what is possible through the establishment of Opportunity Zones.
Baltimore has historically struggled with high rates of both violent crime and poverty, lower per capita income, and lower life expectancies, compared to the national averages. But Baltimore is also no stranger to urban renewal, as demonstrated by the transformation of the neighborhood formerly known as “the Basin” into the “Inner Harbor,” an area that features the homes of two professional sports franchises, the National Aquarium, and multiple historic ships and other maritime attractions on display and open to the public.
Sensing an opportunity to replicate the successful development of the Inner Harbor, the Baltimore City Council approved a $660 million bond in 2016 for what was dubbed the Port Covington project, a waterfront development that would provide a new world headquarters for corporate citizen Under Armour, in addition to shops, housing units, office space, and new manufacturing spaces.
The project was foreseen as a multibillion-dollar boon to the city, and the source of 26,000+ potential new jobs. But the project stagnated for years, as its critics derided the deal as corporate welfare, and the onset of a recession and a pandemic threatened to derail the project for good.
When Port Covington was included in the list of census tracts designated as Opportunity Zones, however, the project not only survived, but expanded, attracting investments from investors including Goldman Sachs, Sagamore Ventures (owned by Under Armour CEO Kevin Plank), and institutional real estate titans MAG Partners and Macfarlane Partners.
Rebranding the area the “Baltimore Peninsula,” the surge of investments finally inspired the Baltimore Board of Estimates to release the first wave of promised bonds in June 2020, a full four years after their initial (pre-QOZ) approval.
And as the first phase of new construction neared completion at the end of 2022, the development team noted that more than one million square feet of new office, retail, and residential space—including a percentage of affordable units—would be available soon.
The project will take years to complete, but developers enthusiastically note that Baltimore Peninsula will ultimately include 14 million square feet of mixed-use development, including mixed-income housing; 2.5 miles of restored waterfront, including areas that will be curb-less, pedestrian-friendly, and accessible only to slow vehicle traffic; and at least 40 acres of parks and other green space, said to be a priority in the community.
A digital aerial rendering of the new Baltimore Peninsula, also known as Port Covington, due to open in spring 2023. (Rendering courtesy of DBOX.)
Baltimore Peninsula, the city’s newest development, is becoming a waterfront shopping, dining, and entertainment destination.
Sagamore Spirit Distillery is located on the Baltimore Peninsula, spearheading the revitalization of the Maryland rye whiskey tradition.
The restaurant has two private rooms: a room upstairs for cocktails and a room in the back alley for stand-up receptions.
Offers a reception and meeting spaces, along with The Bistro restaurant and bar, in the McHenry Row/Locust Point area.
Port Covington is one of the most ambitious development projects in the country, and a project that languished for years. Without the passage of the TCJA in 2017 and the resulting creation of qualified opportunity zones, it’s difficult to assess how or whether the project would have progressed. But the designation of the census tract as an opportunity zone saved the Port Covington project and brought the developers’ ambitious vision much closer to reality. Ultimately, the quality of life for Baltimore residents will be greatly enhanced by the development of an area that had been neglected for decades.
Tax-averse investors may come to the table for the tax incentives first and foremost, but as the example of Baltimore illustrates, a fair amount of capital is also drawn by the rare opportunity to both do good and do well through QOZ investing.
Step-by-Step Guide to Investing in Qualified Opportunity Zones
The advantages of investing in qualified opportunity zones are clear: powerful tax incentives, including deferral of capital gains taxes until December 31, 2026 (with a likely payable date of April 2027), as well as a potential elimination of the capital gains tax on the QOZ investment itself; and the ability to make a positive impact by spurring economic growth in underserved communities across the country.
Deciding to make a QOZ investment is the easy part. As with most investments, the devil is in the details. So let’s take a look at the process of investing in a qualified opportunity zone, from start to finish.
Step One: Sell Something
No matter how many millions of dollars you may have at your disposal, it’s important to remember that the creation of qualified opportunity zones lies in the Tax Cuts and Jobs Act of 2017, a bipartisan piece of legislation that held tax incentives as one of its primary goals (as the name implies).
QOZ investments are meant to defer capital gains taxes; as such, ordinary income is disallowed, and an investor must have a recent capital gain to reinvest in order to contemplate a QOZ investment.
Remember that a capital gain is simply the result of selling an asset at a higher price than its original cost. The asset in question can be real estate, stocks, bonds, cryptocurrency, fine art, livestock, or virtually any other investment that can be sold at a profit.
The statute is quite clear in its definition of a “recent” capital gain, too, as an investor has no more than 180 days from the creation of a capital gain to the reinvestment of the gain in a QOZ.
On day 181, with limited exceptions, the opportunity to reinvest that money in a QOZ, and enjoy all the tax benefits that accompany it, is lost forever.
Step Two: Get In The Zone
With capital gain firmly in hand, the clock is ticking. You have 180 days to find the opportunity zone of your choice.
Fortunately, there’s no shortage of options; there are more than 8,700 qualified opportunity zones in the U.S., including all fifty states, the District of Columbia, and U.S. territories. So accredited investors can find one in the state of their choosing, though admittedly it will be an easier search in the QOZ-plentiful states of Texas, Arizona, and New York.
An interactive map showing all current QOZs is maintained on the website of the Department of Housing and Urban Development. The massive array of geographic options means that it’s possible for a discerning investor to choose to put money to work close to home, 3,000 miles away, or any place in between.
Step Three: Find a Fund
The next step is crucial: investing in qualified opportunity zones means creating a qualified opportunity fund, or simply choosing one that is accepting investment capital. A qualified opportunity fund (QOF) is an investment vehicle, structured as a partnership or REIT, established with the specific goal of investing in QOZ assets. To qualify as a QOF, the fund must hold and invest at least 90% of its assets in QOZ properties and businesses.
While it may seem counterintuitive that an investor hoping to take full advantage of the tax benefits of QOZ investing can’t simply invest in an existing property or business within an opportunity zone, the fact is that all opportunity zone investments must pass through a qualified opportunity fund to qualify for the associated tax incentives. And with 8700+ qualified opportunity zones across the country and its territories, the number of funds accepting investments at any given moment is a moving target. Working with an experienced advisor is strongly recommended as investors sort through the myriad of possibilities in this field.
An advisor could also be instrumental in assisting with the setup of a new fund. While the process is more complex and labor-intensive than simply placing an investment in an existing fund, it is nevertheless possible for any taxpayer to create a new fund simply by filling out IRS Form 8996 and submitting it alongside their federal tax return. The form certifies partnerships or corporations as organizations established for the purpose of investing in qualified opportunity zones.
Step Four: Invest in the Fund
Once a QOF is selected (or created), it’s time to make the investment itself. The fund can choose to deploy it in stocks, partnership interests, or individual business properties, provided that the overall investment meets the 90% rule (and that in the case of existing properties, the funds serve to significantly improve the qualifying property). While many funds choose to focus on a single QOZ, there is no limitation for doing so, and many funds choose to hold investments across several opportunity zones.
It bears repeating here that in order to realize all the tax benefits of the QOZ investment (especially the tax-free gain after the ten-year holding period), only realized capital gains, not ordinary income, are eligible to invest in qualified opportunity funds; it’s also critical that the IRS’ deadline of making the investment within 180 days of the realization of the capital gain be strictly followed.
Step Five: Sell Your Investment… Someday
While steps one through four all take place in a whirlwind interval of no more than 180 days, step five is designed to take place years later. How many years, of course, is up to the investor. But to leverage the tax incentives, the Qualified Opportunity Fund (QOF) investment will be held at least until December 31, 2026. At present, that’s the maximum deferral offered for the payment of the capital gains tax on the original investment in the fund. (Legislation is currently under consideration to extend that date another two years or more; your advisor should keep you apprised of any developments in this regard.)
Holding the Qualified Opportunity Fund (QOF) investment for a minimum of ten years offers the elimination of any further capital gains taxes entirely, so it stands to reason that a decade-long investment is a practical goal when contemplating opportunity zone investing. The combination of an initial tax deferral, followed by the promise of a tax-free investment, is a compelling advantage of QOF investments over other traditional forms of investment that are accompanied by taxes on investment gains and dividends.
States That Do Not Conform with QOZ Tax Benefits
We’ve spent a lot of space in this guide outlining the benefits of a QOZ investment for investors who are seeking a unique investment coupled with a generational tax deferral opportunity. In addition to deferring the payment of Federal capital gains tax on a realized gain until December 31, 2026, investors can also profit from the subsequent QOZ investment being entirely free of Federal capital gains taxes, provided it’s held for at least ten years.
We’ve also mentioned that state capital gains taxes are almost always deferred and/or eliminated in most states as well.
Almost always . . . in most states
It’s time to drill down deeper into how the various states treat QOZ investments for the purposes of capital gains taxes. Let’s start with the fact that while Federal capital gains taxes are consistent across all 50 states, capital gains taxes vary widely on the state level, ranging from having no tax at all on capital gains to 13.3%. Not surprisingly, it’s California that’s the dubious winner in this category, though New York State is a close second at a top rate of 12%.
There are eight states having no income tax: Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, and Wyoming. These states also do not tax capital gains.
Of the eight, only New Hampshire has an investment income tax, but it is aimed at interest and dividends instead of capital gains and is on a pace to be phased out by 2027.
Strategies aimed at the deferral or elimination of Federal taxes are still appropriate to pursue, but it’s not necessary to focus on non-existent state taxes for these states.
For the remaining 42 states, capital gains tax rates range from 2.9% to 13.3%, though the majority falls within the 4-6% range. Of these 42, an overwhelming majority have state laws that conform to the Federal law by offering deferral of capital gains taxes on any gain reinvested into a QOZ fund, and freedom from any capital gains tax on the QOZ investment itself, provided it is held for at least ten years.
There are, however, a handful of non-conforming states, and once again, the Golden State is at the top of the list (or the bottom, depending on your perspective).
In addition to the three states with no conformity whatsoever, Arkansas and Hawaii conform to Federal QOZ benefits, but only for opportunity zones located in their respective home states.
Several states initially resisted conformity, either intentionally or through legislative inaction, but with the exceptions noted above, all have come to embrace the QOZ tax benefits on the state level. Most recently, Massachusetts issued TIR-23-5, which extended QOZ benefits to all taxpayers after originally restricting conformity to corporate taxpayers only (the reverse image of Pennsylvania, which conformed at the personal income level only before relenting in 2019 to include all taxpayers).
Finally, there are states with additional incentives built into their conformity legislation, geared towards encouraging their taxpayers to look to their own state first before seeking QOZ funds elsewhere.
Ohio, for example, offers an income tax credit for investments in Ohio-based QOZs; West Virginia permits deductions from income from business activity that takes place in West Virginia opportunity zones. Wisconsin offers a pair of incentives: for individuals, a subtraction from income for an investment in an in-state QOZ fund, and for corporate taxpayers, an additional capital gain exclusion or adjustment in cost basis, for an investment in a Wisconsin QOF. Investors would do well to examine the situation in their own state before looking elsewhere for QOZ fund opportunities.
As we have emphasized repeatedly, it’s critical to have an experienced and knowledgeable advisor on your team to address these complexities.
Residents of a conforming state who invest in a QOZ fund that is based (in whole or in part) in a non-conforming state may find themselves with an unexpected tax bill. This is especially important because, while many QOZ funds are limited to properties in a specific state or locality, a number of them feature properties in several states.
Remember that accredited investors already have access to our Qualified Opportunity Zone Masterclass, an excellent primer that will prepare you well for QOZ investing and educate you more extensively on the benefits of QOZ funds while also enabling you to avoid potential pitfalls. Make sure to check out the trailer for the masterclass that follows.