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Understanding qualified opportunity funds
In 2017, the Tax Cuts and Jobs Act established a tax rule that allows investors to defer their capital gains taxes by reinvesting their capital gains into qualified opportunity funds.
What is a qualified opportunity fund?
Qualified opportunity funds (QOFs) mean to drive business and real estate investments toward low-income or economically distressed areas of the country. The federal government incentivizes investors to put money into these funds by offering preferential tax treatment on capital gains. Investors can reinvest any realized capital gains into these funds to defer taxes they owe on their gains, and ultimately can greatly reduce their tax bill down the road.
Which areas qualify for QOF investment?
Each qualified opportunity fund facilitates investments into businesses or properties within qualified opportunity zones (QOZs). States can nominate low-income communities (and, perhaps, their surrounding areas) to be designated as opportunity zones, and the nomination must be certified by the U.S. Treasury Department. Once a location is selected and approved, qualified opportunity funds can begin investing in properties and businesses within the opportunity zone to make improvements.
What happens to the money once it's in the fund?
Qualified opportunity funds pool money from investors and then use it to purchase properties within an opportunity zone. The fund must then make "substantial improvements" to the property within a 30-month period and which are equal to its value at the time of purchase. For example, if a qualified opportunity fund purchases a building for $1 million, they have 30 months to make a minimum of $1 million worth of improvements to that building.
By encouraging investment into opportunity zones, the government hopes to propel economic growth through job creation, business activity and expanded housing options. Whether that plan will work is up for debate: A June 2020 study by the Urban Institute found that though there have been investments that made community impact, oftentimes the capital has not gone toward the areas with the greatest need, but rather has benefitted real estate developers more.
On the other hand, the White House Council of Economic Advisors assessed the initial impact of qualified opportunity zone tax breaks in August 2020. It found that by year-end 2019, qualified opportunity funds raised $75 billion in private investment, which CEA projections show could shift 1 million people from poverty to self-sufficiency, reducing poverty in opportunity zones by 11%.
Why invest in qualified opportunity funds?
Say you’ve sold an asset (real estate, investments, a business, etc.) and have a large capital gains tax liability on your hands. Or you’d like to offload an investment, but the capital gains tax consequences have kept you from doing so. By rolling those capital gains into a qualified opportunity fund, you can defer and reduce your capital gains tax liability, diversify your portfolio and make a positive impact.
There are two main tax benefits of investing in qualified opportunity funds:
You can defer paying taxes on your original capital gain until the tax year 2026, which means you won't actually pay taxes until you file your 2026 tax return in 2027.
When investing in qualified opportunity funds, the longer you hold onto your investment, the greater your overall tax benefit:
If you keep your investment for more than 5 years, your cost basis increases by 10%, which effectively excludes you from having to pay taxes on 10% of your realized capital gain.
If you keep your investment longer than 7 years, your cost basis increases by an additional 5%, bringing your capital gains tax exclusion up to 15%.
If you hold your investment beyond 10 years, you'll owe no capital gains on any additional appreciation beyond what you paid in 2027.
“It’s very substantial. The net benefit to investors or the impact is between 40% to 50% higher after-tax returns than a non-opportunity zone investment,” says Jill Homan, president of Javelin 19 Investments, a Washington, D.C.-based real estate and investment advisory firm focused on qualified opportunity zones.
Qualified opportunity funds also provide investors with a way to diversify their portfolios outside of the traditional stock and bond markets; they can branch out into real estate or startup businesses. Investors can choose from single-asset investment opportunities or multiasset funds that invest in a collection of properties or businesses, often spread across different asset classes or geographies.
Caveats to keep in mind
As with any tax break, many rules apply. You must reinvest your eligible gains into a qualified opportunity fund within 180 days from when the gain would be recognized to qualify for these tax advantages. And, not all gains are eligible: Only capital gains or qualified 1231 gains (gains on certain types of business properties) recognized for federal income tax purposes prior to Jan. 1, 2027, will count. Also, these gains cannot be generated from transactions with a related person.
Depending upon the qualified opportunity fund, you may need to be an accredited investor in order to participate. That means having earned income of at least $200,000 in each of the past two years ($300,000 with a spouse) and net worth, alone or with a spouse, of at least $1 million in investable assets. Even if the qualified opportunity fund you select doesn’t require accredited investors, holding the investment for the long term increases your tax benefits, so make sure to invest funds you won’t need access to for a while.
Investing in qualified opportunity funds will also require some due diligence on your part. Since these funds aren’t rated by typical fund rating agencies such as Morningstar, Lipper or S&P, you’ll need to examine the assets within the fund to gain comfort with the management team, investment strategy and potential returns.
However, Homan points out that compared with traditional private equity, investors often have more visibility into the underlying investments within the fund. Once investors roll gains over, qualified opportunity funds must deploy invested capital quickly to satisfy certain operating and testing requirements, which allows investors to obtain up-to-date information about the investments and deals they are funding.
How to start investing in qualified opportunity funds
In order to make sure you’re following the rules, considering all potential implications and filing the appropriate paperwork, consulting with tax or financial advisors well-versed in qualified opportunity funds can help smooth the investment process.
“Whether an investor is eligible to use opportunity zones depends on the character of the gain and timing of that gain,” Homan says.
She recommends that investors who are interested in qualified opportunity funds and have gains start out by talking with their accountant. “That’s really your first step — to become equipped and know this is the timing I’m working with, this is the amount of capital I have, and then your next step is looking at your options in the marketplace.”
Despite needing to jump through some hoops, opportunity zone investments are compelling.
“For investors, there are a number of funds to evaluate, and you can also look at investing in individual deals. This is a really active marketplace and one of the most significant tax incentives in a generation. It’s going to do a whole lot of good,” Homan says.
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