Qualified Opportunity Funds: How QOFs Work, Pros and Cons
Qualified opportunity funds are a way to help invest in distressed communities while saving on capital gains taxes.
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What is a qualified opportunity fund?
A qualified opportunity fund (QOF) is an investment fund that pools money from investors and uses it to invest in businesses or properties in low-income or economically distressed areas of the country. Investors in QOFs get preferential capital gains tax treatment. The intent of QOFs is to revitalize communities.
People who have sold investments at a profit may be able to defer or reduce capital gains tax on those profits if they reinvest those profits in a qualified opportunity fund.
Tax benefits of 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:
Tax deferral. You can defer paying taxes on your original capital gain for five years or until you sell your QOF investment, whichever comes first.
The longer you invest, the bigger the break. The longer you hold onto your QOF investment, the greater your overall tax benefit:
If you keep your QOF investment for more than five years, the government lets you increase the cost basis on your original capital gain by 10%, which effectively excludes you from having to pay capital gains tax on 10% of your original capital gain. If you've invested in a qualified rural opportunity fund, the benefit is bigger; your cost basis increases by 30% instead of 10%.
If you keep your QOF investment longer than seven years, your cost basis increases by an additional 5%, bringing your capital gains tax exclusion up to 15%.
If you hold your QOF investment beyond 10 years, you'll owe no capital gains on any additional appreciation beyond what you paid.
“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.
Disadvantages of qualified opportunity funds
Many rules apply to QOFs, some of which may be high hurdles for certain investors.
Quick turnaround required. If you want the capital gains tax break, you have to reinvest your eligible capital gains into a qualified opportunity fund within 180 days of when the gain would be recognized.
Some gains don't qualify. Only capital gains or qualified 1231 gains (gains on certain types of business properties) recognized for federal income tax purposes count. Capital gains you got from transactions with a related person don't count.
The funds may have personal requirements. 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.
Long investment horizon. To get the maximum tax benefits, you have to hold your QOF investment for a long time, so make sure to invest funds you won’t need for a while.
Homework required. Investing in qualified opportunity funds requires due diligence on your part. QOFs aren’t rated by typical fund rating agencies such as Morningstar, Lipper or S&P, so you’ll need to examine the assets within the fund and get comfortable on your own with the management team, investment strategy and potential returns. However, Homan points out, QOF investors often have more visibility into the underlying investments within the fund compared to traditional private equity. 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.
Which areas qualify for QOF investment?
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.
Opportunity funds that invest primarily in rural areas are called qualified rural opportunity funds.
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 qualified opportunity fund?
Qualified opportunity funds pool money from investors and then use it to purchase properties within an opportunity zone. They must follow two rules regarding the use of the money:
The fund must make "substantial improvements" to the property within a 30-month period after investment.
The improvements have to be in an amount equal to the investment 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.
The idea is to propel economic growth through job creation, business activity and expanded housing options. Whether that plan is effective 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 (CEA) 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%.
How to invest 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 who are 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.
