Today, we have a guest post from CrowdStreet, our affiliate partner. I started investing in real estate crowdfunding with them earlier this year and I’ve had a great experience so far. Recently, I noticed some projects are designated as “Opportunity Zone.” I don’t know anything about these so I asked CrowdStreet to tell us more about them. These projects sound like a good way to reduce tax. Check it out.
How Investing in Opportunity Zones Works
The goal of the Opportunity Zone program, created as part of the 2017 Tax Cuts and Jobs Act, was to attract private capital for long-term investment in low-income communities by providing meaningful capital gains tax benefits to investors in the form of tax deferral, reduction, and elimination.
By investing your qualifying capital gains–meaning gains earned by selling stocks, a business, real estate, etc.–into a Qualified Opportunity Fund (QOF), it’s possible to obtain the following tax benefits:
- Tax deferral of your reinvested capital gains;
- Tax reduction of those reinvested capital gains (via a step-up in basis) if certain criteria are met–a 10% reduction if the investment is held for 5 years and 15% reduction if the investment is held for 7 years; and
- The elimination of capital gains tax for gains resulting from the sale of your QOF investment (provided the investment is held for a minimum of 10 years).
These tax benefits would be on top of any potential dividends you may earn while invested in the property.
How to Invest in Opportunity Zones.
Unlike other direct commercial real estate investments, in order to get any of the tax benefits associated with investing in an Opportunity Zone, you have to invest your qualifying capital gains into a QOF and not directly into a property in the QOZ.
A QOF needs to meet certain requirements, the biggest one is that it must invest in Qualified Opportunity Zone Property, which can include Qualified Opportunity Zone Stock (a domestic corporation that qualifies as a Qualified Opportunity Zone Business), Qualified Opportunity Zone Partnership (domestic partnership that qualifies as a Qualified Opportunity Zone Business), or a Qualified Opportunity Zone Business Property.
A Qualified Opportunity Zone Business Property could consist of one or more real estate development or redevelopment projects. To qualify, the property also has to be substantially improved, meaning the basis (essentially the value) of the property needs to double within a 30 month period. This means that all QOZ real estate projects are going to be considered “Opportunistic,” which is the riskiest segment of commercial real estate investment opportunities. These kinds of projects often target higher rates of return for the investors but also come with more risks–permitting issues, construction delays, the rising cost of materials, finding tenants–that could impact the success of the project.
While almost any asset could be designated a Qualified Opportunity Zone Business Property, our research report explains why multifamily properties are expected to be a key asset in QOFs, thanks in part to the higher proportion of small to medium-sized multifamily properties that typically cater to lower-income residents in these economically underserved communities.
What Makes QOFs Different
An important feature of most QOF investments is that they are intentionally long-term. In order to receive the full tax benefits–both the capital gain reduction and exclusion–you have to hold the QOF investment for at least 10 years.
It is also important to note that, unlike other commercial real estate investments, you have to invest your qualifying capital gains into a QOF within a certain time frame, generally 180 days from the date of the sale generating capital gains (although this time frame may be different for different types of capital gains). There are various nuances in the proposed regulations that make it important for you to work with a tax advisor to ensure you will be eligible to get the full tax benefits of investing in a QOF.
When a Fund is Finally a Fund
Contrary to what the term “fund” implies, to date, most real estate-focused QOFs have contained just one property. While investors can reap the potential tax benefits by investing in single asset QOFs (remember, you have to invest in a fund to invest in the property), the main benefits of investing in a true real estate-focused fund, including diversification across other assets, sponsors, geographies, and risk mitigation, have not been part of the mix.
But the most recent round of proposed regulations contains a provision that makes it easier for QOFs to invest in multiple properties, allowing for a more diversified QOF portfolio with a single investment. (It’s important to note that taxpayers cannot totally rely on this provision until the regulations are finalized, which adds another element of risk to the investment.)
Reporting suggests that American households have $3.8 trillion and corporations have $2.3 trillion in unrealized capital gains. All of that money could flow into Opportunity Zones, provided investors find the kinds of opportunities they are looking for.
CrowdStreet has published several Opportunity Zone-based projects on our Marketplace this year, one of which ended up our biggest individual raise ever. We expect to see a large chunk of that $6.1 trillion moves into QOFs in 2020 as more and more investors take advantage of this unique investment opportunity.
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