By David O'Brien, CFP, CAIA, Senior Consultant at Asset Strategy.
The Opportunity Zones Program, enacted as part of the Tax Cuts and Jobs Act of 2017, incentivized investment in under-developed and/or struggling areas of the United States by offering investors Tax Deferral, a basis step-up of deferral gains, and elimination of the capital gains tax on the growth of the QOF Investment if held for 10 years. Going forward investors in Qualified Opportunity Zones (QOZs), which are funded by Qualified Opportunity Funds, or QOFs, will not get any step up in their (cost) basis when they ultimately pay their deferred taxes in 2027. Meaning investors receiving a reduction in their tax bill due to the step up in basis will have a higher after-tax return than investors who don’t. This clearly makes QOFs less attractive, but does it mean they aren’t a good investment and the QOZ program is dead in the water? Absolutely not. QOFs are still a viable solution for investors with capital gains and the QOZ program is alive and well.
When first introduced, QOFs offered investors 3 key tax benefits:
- Tax Deferral Until 2026: Individuals or entities investing capital gains into QOFs may defer the tax on those gains until either the end of 2026 or until the asset is disposed if sooner.
- Basis Step-Up of Deferral Gains: Capital gains invested in a QOF for at least 5 years prior to 12/31/2026 received a step up in their basis of 10% and 15% if the investment is held for 7 years.
- No Tax on Capital Gains Appreciation of a QOF Investment: Investors who hold QOFs for a least 10 years will get a step up in basis to current value which will result in paying no capital gains taxes on their QOF investment when it is sold.
While the step up in cost basis has gone away, the other two benefits: capital gains tax deferral and the no tax on capital gains appreciation remain. These 2 benefits can make QOFs compelling options for investors with realized capital gains.
No Tax on Capital Gains Appreciation
This is by far the biggest benefit of the QOF program. If a QOF is held for 10 years, investors will pay no capital gains tax on that investment. When a QOF investment is sold after being held for 10 years or longer, the tax basis is ‘stepped-up’ to fair market value and there is also no depreciation recapture on the sale of real estate.
Deferral of Capital Gains Taxes
Another indirect benefit of a QOF investment has to do with the return on invested capital during the initial deferral period. Instead of paying taxes, those funds are invested in a QOF until taxes are due in early 2027, which may generate additional returns for QOF investors.[i]
What About Qualified Opportunity Businesses?
The majority of the QOFs that have raised capital from investors have been focused on real estate development, however, the program also allows individuals to invest in Qualified Opportunity Businesses (QOBs). The rules for investing in QOBs are complex, and the risks associated with investing in new businesses is historically higher than investing in real estate. According to Novogradac and Company, a leading QOF consulting firm that tracks 1,171 QOFs, which include QOZs and QOBs, as of June 30, 2021, a little over $17.5B had been invested in these funds. Of that, most of the funds are invested in residential and commercial real estate, with less than $1B invested in funds focused on QOBs.[ii]
Investors in QOFs that focus on real estate development will have the opportunity to receive tax favored income from rents along with debt financed distributions, prior to the end of their10-year holding period, with no recapture on the sale of the QOF assets. This can significantly improve the net after tax return on a QOF investment compared with a similar non QOF real estate investment. Many QOFs focused on real estate development also intend to take advantage of this by refinancing projects after completion and stabilization and distributing those proceeds tax free to investors before their taxes are due in 2027.
During CAIA Seattle’s January 27, 2022 webinar Is Opportunity Zone Fund Investing Still Compelling, Kevin Shields, CEO and founder of Griffin Capital, and a leader in the QOF space, called the rush of investing capital gains in QOFs to take advantage of the basis step ups prior to both the December 31, 2019 and December 31, 2021 deadlines “comical.” Shields pointed out the difference internal rate of return (IRR) in a QOF investment made in 2021 vs one made in 2022 was less than 0.2%.[iii] Overall, the after-tax IRR in a QOF is still considerably higher than the same financial investment made in another type of real estate investment vehicle. Mr. Shields further pointed out Griffin Capital had seen significant increases of investments in December of 2019 and again in 2021. His point being that, by doing proper due diligence and selecting a quality QOF could potentially have a much larger impact on an investor’s Net IRR than the 10% or 15% step-up in basis on their original gain would have. Spending time to research and invest in the QOF that performs well (but may not have the benefit of the step-up in basis), as opposed to rushing to choose a QOF solely to get the step-up, is a better choice. Investing in a QOF with a solid business plan from a quality manager will likely have a larger impact on investor’s returns than the actual benefit of the step up itself.
While it is unclear exactly how much money is invested in QOFs to date, the amount is certainly in the billions. On the November 21, 2021 Opportunity Zones Podcast, Shay Hawkins, Chairman and CEO of the non-profit Opportunity Funds Association indicated the QOF program still enjoys strong bipartisan support in Congress. Shay was optimistic there is still time for Congress to extend the program. Owing to delays early in the program due to the rules being refined and clarified and impacts of COVID-19, H.R. 970 – Opportunity Zone Extension Act of 2021 has been filed to extend the program an additional two years and re-introduce a basis step-up. Unless Congress acts, the program will continue to be available to investors with realized capital gains until the end of 2026.
As I wrote in my December 19, 2019 article Considering Investing in Qualified Opportunity Funds? Caveat Emptor, investors need to do their homework prior to investing in a QOF. The potential tax benefits associated with QOFs can make a good investment even better. They cannot transform a poor investment into a good one. Still, while the value of the initial tax deferral will diminish as we get closer to the tax bill being due, the elimination of the tax bill on a QOF investment held for 10 years is still a compelling reason to invest. This means that, depending on the underlying investment and the individual investor, QOFs still are still a sound investment that make as much sense today as they did when the program was first introduced.
[i] As 2026 approaches, this benefit will lose its value.
[ii] The Novogradac database is limited to funds that either self-report or file with the SEC Novogradac’s list includes single- and multi-asset funds, but it does not include proprietary or private funds that are owned and managed by their principal investors.
[iii] Assuming the same investment returns.
About the Author:
David O'Brien, CFP, CAIA works closely with financially successful individuals, families and business leaders to develop custom investment portfolios that reflect their specific financial goals, objectives and aspirations. He believes it is his responsibility to your finances with your personal values, using appropriate strategies and disciplines to help achieve your specific goals.
Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. There are risks associated with investing in real estate properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity.
Certain QOZ areas may not be able to appreciate as predictably as more established areas. Some neighborhoods may be more accommodating to development than others, impacting the success of the investment. Development and redevelopment of real estate traditionally have more risk than other types of real estate strategies. The availability and cost of construction and development financing is uncertain
and represents a risk inherent in the execution of a QOF strategy. The rules and regulations of the QOZ Program are complex, compliance with the QOZ Program comes with significant challenges. QOFs tend to be illiquid investments for ten or more years.
This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation.
Securities offer through Concorde Investment Services, LLC. (CIS), member FINRA/SIPC. Advisory Services offered through Asset Strategy Advisors, LLC (ASA), a SEC Registered Investment CIS and ASA are separate companies.