What Is an Opportunity Zone and How Does It Work?
Qualified Opportunity Zones fuel tax-incentive funds approved by the Treasury Department that encourage investment in impoverished and underdeveloped areas looking for capital development. Stemming from the Tax Cuts and Jobs Act, the idea of these Opportunity Funds is to move billions of dollars into low-income communities by providing a tax deferment vehicle similar to how a Section-1031 Exchange works. There are currently 8,764 Opportunity Zones nationwide throughout all 50 states, Washington D.C., and U.S. territories.
How Do Opportunity Zones Work?
The incentive of Opportunity Zones to an investor is the creation of a fund that allows for tax-deferment of capital gains at a guaranteed rate while also providing tax breaks on the appreciation from the fund itself. For example, if you were to double your investment on a stock or real estate purchase and sell, you could be looking at a massive tax bill that you’d rather not have to pay right away. To avoid Uncle Sam, you could look into investing those capital gains in an Opportunity Fund. This defers that original tax bill until 12/31/2026. There’s also the extra incentive of diminished taxes on capital gains made within the Opportunity Fund.
If that sounds complicated, we completely understand. Let’s break this down further and explain how Opportunity Funds work.
That’s right, if you wait for your investment to appreciate over 10 years, you’ll owe the United States Internal Revenue $0 on your capital gains from the Opportunity Fund. These investments offer a guaranteed return rate of 6-10%. Considering the stock market averages around 8% per year, investing in a safer, tax-friendly asset that supports a community’s growth sounds like a win-win to us!
Before going further, we should mention the investment must accrue five, seven, or 10 years before the 12/31/2026 deadline in order to receive the “step-up basis” decrease to your capital gains taxes from the original investment. This means you need to have been in the fund for enough time to qualify for these benefits. However, this stipulation does not apply to the full-tax exemption on the Opportunity Fund’s appreciation as long as the investment is held for 10 years before the 12/31/2047 deadline.
Missing these deadlines should not dissuade you from investing in Opportunity Funds. For example, if you plan on retiring before 12/31/2026, this investment could still be prudent if you’re looking for a growing tax-deferment vehicle that will not be taxed at your current income levels.
What Exactly Are These Opportunity Zones Funding?
The money financing Opportunity Zones can be used for a multitude of projects. This could include:
- Commercial Real Estate
- Industrial Real Estate
Any real estate project must result in “substantial improvement” in the property values and must occur within 30 months. This means if a property is purchased for $50,000, there must be at least $50,000 worth of improvements. There’s also the consideration of Opportunity Funds funding “sin” businesses. These enterprises usually include liquor, gambling, and pornography. However, funding for Opportunity Zones is highly restrictive with these activities, and typically, exceptions are only made for casinos.
How Does a Community Qualify to Become an Opportunity Zone?
According to the U.S. Census tract, approximately 12% of the country is a designated Opportunity Zone. To qualify to become an Opportunity Zone, the area must be nominated by a state Governor or the D.C. mayor to the Treasury Department. The Treasury Department then assesses the area and assigns the Opportunity Zone designation based on the following criteria:
- Poverty Rates
- Unemployment Rates
- Home Values
These standards are not fully established by the Treasury Department. However, the Urban Institute research found that there is a strong correlation between these socioeconomic attributes and the Opportunity Zone designation.
The idea of Opportunity Zones is to funnel in money and support underinvested areas for their long-term success. By the date these designations are supposed to expire (12/31/2028), the hope is that these areas will have achieved enough socioeconomic progress to not be deemed Opportunity Zones any longer. Accomplishing this objective will provide for a better community that can generate investment and growth on its own as we approach the second half of this century.
How Do Investors Get Involved?
Most Qualified Opportunity Funds raise money from outside investors with an SEC exemption under Regulation D, Rule 506(b) or 506(c), which limits investors to those with an accredited designation. According to Investopedia, an accredited investor “is anyone who meets one of the below criteria: Individuals who have an income greater than $200,000 in each of the past two years or whose joint income with a spouse is greater than $300,000 for those years, and a reasonable expectation of the same income level in the current year.” These rules are made to protect the general public from severe financial restraint due to the failure of the fund.
The typical investment minimums these Opportunity Funds are seeking range from $25,000 to $1,000,000.
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