An Introduction to Qualified Opportunity Zone Investments
It is in this spirit that the US Government and the IRS have created a unique and timely opportunity for investors to embrace this long-standing American value today—namely, Opportunity Zones (OZ).
Opportunity Zones were enacted into law by the Tax Cuts and Jobs Act on December 22, 2017, with the final Treasury Department regulations being published as late as the Spring of 2019. Consequently, the Opportunity Zone tax provisions are not widely known and understood by most taxpayers and their advisors.
The Opportunity Zone tax law (IRC §1400Z) is one of those rare and unique opportunities in tax legislative history where both sides of the political spectrum have come together on a bipartisan basis to present investors with both a significant tax advantage (tax break) and an opportunity to reinvigorate targeted high impact markets throughout the United States.
The initial bill that found its way onto the Tax Cuts and Jobs Act was originally coauthored by Congressmen Tim Scott (R-SC) and Cory Booker (D-NJ) and championed in the White House by Ivanka Trump.
With values in the stock and real estate markets at all-time highs, Opportunity Zone investments present investors with a timely and tremendous opportunity to realize builtup capital gains, defer and even eliminate capital gains tax, and redeploy the full untaxed gain into uncorrelated investments in undervalued assets with significant upside potential. Thus, OZ provides diversification, potential income, and significant tax advantages, all while helping society reinvigorate targeted communities throughout the country.
However, time is of the essence for the investor to “do well by doing good” and take full advantage of opportunity zones, as the tax regulations have certain sunset provisions. In the pages to follow, we present the limited time window for this opportunity as well as discuss the key tax advantages, outline OZ investment offerings, define investor eligibility, and reference possible risks.
A Limited-Time Window of Opportunity
Unless Congress extends the program, investors have until December 31, 2019, to roll over capital gains and enjoy a 15% capital gain exclusion if investments are held in OZ at least 7 years. Investments after 2019 and before December 31, 2021, would be able to exclude 10% of the invested capital gain if investments are held in OZ at least 5 years. As discussed in more detail below, the remaining net capital gain that is rolled into the OZ is deferred until December 31, 2026 or the sale of the OZ, whichever is earlier. US equity market investors have enjoyed a bull market for stocks over the last decade following the 2008 Financial Crisis and Great Recession.
However, these gains may be threatened by recent severe market volatility, global trade wars, and the political and economic risks of future elections. These factors may point to a short window of opportunity to lock in gains through asset liquidation or reallocation.
For most investors with the long-term capital gain tax rate of 20 percent plus the Affordable Care Act tax rate of 3.8 percent, and the state and local tax rate of around 7 percent, the total tax bill for a liquidation could be as high as 30 percent! They are also faced with limited investment options that would be classified as discounted with significant upside potential.
Reallocation without Taxation!
Opportunity Zones present accredited investors who have significant capital gains in their portfolios with the ability to defer taxation for up to 7 years—until December 31, 2026—by re-investing their capital gains into a Qualified Opportunity Zone Fund (QOZF). In should be noted that the original principal from the down leg sale does not need to be invested in order to protect the capital gain portion of the sale from immediate taxation and that investors are allowed up to 6 months (180 days) to diversify their portfolios and invest in an asset class which has not yet seen significant appreciation by reinvesting capital gains in an OZ.
Another powerful feature of the QOZF is the tax-free nature of future capital gains on appreciation of the QOZ investments. If the investment is held in the OZ for a full 10 years, then the gain on the QOZ investment may be liquidated tax-free (i.e., a full exclusion of the capital gain on the QOZ investment). This benefit cannot be overstated for long-term growth-oriented investors. However, please note that gain or appreciation is not guaranteed and your investment may lose value.
Most stock market investors have no idea that this option exists, nor are their Wall Street financial advisors likely to suggest something to their clients that will effectively reduce the advisor’s income by reducing their assets under management (AUM), even if their firm does offer Qualified Opportunity Zone Funds. It is our mission as Cornerstone Real Estate Investment Services to reach out to CPAs and estate planning attorneys to help them make their clients aware of this extremely valuable new investment option.
What Are the Benefits?
The tax incentives for investors are mainly in the following three categories:
- Tax Deferral
- When an asset (stocks, bonds, real estate, etc.) is sold and the capital gain from that asset is invested into a QOZ fund or business, then the tax on the gain will be deferred and not recognized until the earlier of the date on which the QOZ investment is sold or December 31, 2026. The portion of sales proceeds that are a return of capital may be redeployed or cashed out without taxation. The deferral would apply to both federal and most state income taxes.
- In advance of the investor’s 2026 tax bill from the gains on a relinquished asset that was rolled into the QOZ investment, there is the possibility that the QOZ investment sponsor/manager will refinance the OZ asset based on the asset value appreciation to that date and make a tax-free distribution to investors to help them pay all or a portion of their tax bill. If this can be accomplished, then the original capital gain rollover would then be effectively tax-free, given that it was paid with additional dollars from the QOZ investment. Of course, there would be a decrease in basis to the investor in the QOZ investment but if the QOZ investment is ultimately held for 10 years or longer, the gain over the basis would be totally excluded from income tax.
- If, on the other hand, a tax-free distribution is not made by the sponsor then investors will need to find an alternative source of funds to pay their tax bill at the end of 2026 as their initial rollover funds would be tied up in the QOZ investment.
- It should be noted that gains from rental real estate will qualify for the OZ capital gain deferral as described above but that the investor will have to pay tax on allowed or allowable depreciation recapture. Depreciation recapture is taxed at a federal rate of 25% and could be material if the relinquished property was held for many years. Consequently, investors selling rental real estate may want to consider a like-kind IRC §1031 exchange investment rather than a QOZ investment.
- Step-up in Basis
- The basis of the invested gain is increased by 15% if the QOZ investment is held for at least 7 years. So, in order to enjoy the full 15% reduction in the rolled-over capital gain, the QOZ investment must be made by or before December 31, 2019. Investments made between January 1, 2020, and December 31, 2021, will enjoy an increase in basis of only 10% as the investment would have been held in the QOZ for 5 years as prescribed by the statute. Per the current statute, investments made after December 31, 2021, would have to pay tax on the full gain but would still have the deferral until December 31, 2026.
- Tax-free Growth
- Any appreciation on the invested gains while in the QOZ investment is excluded entirely from federal and most state taxable income if the investment is held for at least 10 years. Assuming a successful OZ real estate development or significant OZ business growth, the benefits of building wealth with this tax-free advantage cannot be overstated.
- OZ investors desiring full tax advantages should be prepared for a long-term hold without liquidity and may also want to consider the advantages that the investment could present to themselves and their heirs. Unlike a §1031 exchange deferral, proceeds from the eventual sale of the QOZ investment would have a new tax basis and could provide significant income-tax sheltering advantages if reinvested in depreciable real estate.
Professional Real Estate Investment Management
Opportunity Zone Funds allow investors to enjoy the benefits of passive Real Estate Investment without the hassle of direct management, maintenance and oversight typically required with active real estate ownership.
Stock market investors may not be accustomed to the advantages that real estate investors have been enjoying for decades, namely, income-tax shelter due to tax depreciation deductions and capital gain tax deferral due to §1031 like-kind exchanges.
Where are Opportunity Zone Locations?
Opportunity Zones (“OZs”) have been designated in every US state, Puerto Rico, and the Virgin Islands. An Interactive map of designated zones can be found at:
Who is Eligible?
Eligible investors include any taxpayer having capital gains (from stocks, bonds, real estate, selling a business, etc.). Investors must invest their capital gains in a Qualified Opportunity Zone within 180 days of a realized capital gain event.
If the investment is made through an investment fund or a private REIT, the investor must meet the net worth or income requirements for an “accredited investor” per the 1933 Securities Act. The Security and Exchange Commission defines an accredited investor as an individual with either $1 million in net worth (excluding the equity in one’s principal residence due to the Dodd-Frank Act) or net income for the last two years of $200,000 or greater ($300,000 if accreditation is based on a married couple) with a reasonable expectation of such earnings in the current year. If you do not meet this definition of an accredited investor, please notify us immediately and disregard this message and its contents.
OZ Fund Requirements:
Qualified Opportunity Zone Funds must hold at least 90% of assets located in OZs or stock/interest in qualified opportunity zone businesses (“QOZB”). QOZBs are trades or businesses in which substantially all of the tangible property owned or leased are located in qualified OZs. Currently, identified investment types in OZs are commercial real estate development or renovation, opening new businesses, expansion of businesses into OZs, or larger expansions of businesses already located in OZs. Cornerstone OZ Fund Offerings:
Along with our broker-dealer, Cornerstone has performed due diligence review and approved multiple QOZ investments. These investments are offered under Regulation D of the 1933 Securities Act and include QOZ funds (limited partnerships) and QOZ Real Estate Investment Trusts (REITs). These QOZ investment offerings are issued by various sponsors. The offerings include investments diversified over multiple designated opportunity zones and offerings that invest in a single opportunity zone asset. Accordingly, Cornerstone clients have multiple and diverse QOZ investments to choose from or to build a diversified personal QOZ investment portfolio.
QOZ Investment Process:
As stated above, QOZ investments are offered under Regulation D of the 1933 Securities Act. Accordingly, prospective accredited investors must receive and review a Private Placement Memorandum (PPM) for the investment. The PPM is a full-disclosure document that presents all material facts and all possible risks of the investment. The Act also requires the issuer (sponsor), its council, and the securities broker-dealer to perform significant due diligence.
As the fund or REIT has already acquired the QOZ assets, secured any possible debt, and performed its due diligence, the qualified investors may fund and close on a QOZ on a timely basis. Investments may be closed within a few days of completing prerequisite subscription documents (i.e., brokerage forms, purchase questionnaires, and purchase agreements). Accordingly, investors may easily satisfy the requirement to invest in the OZ within 180 days of the liquidation of their down-leg relinquished asset. Please contact your registered representative for available QOZ investment PPMs and offering material.
QOZ Investment Tax Reporting
On an annual basis, the QOZ funds or limited partnerships will produce a timely filed Form K-1. The Form K-1 will report partner-allocated taxable income and pass-through tax deductions for depreciation. These items will then be reported on the investor’s 1040 individual income tax return on Schedule E.
If a QOZ investment is structured as a REIT investors will receive a standard Form 1099. The form will report the investor’s share of taxable distributions or dividends from the REIT (net of depreciation and other deductions). These items would then be reported on the Investor’s 1040 individual income tax return on Schedule B.
QOZ Investments vs. §1031 Like-kind Exchange Investments
The differences between §1031 like-kind exchange investment and qualified opportunity zone investments are numerous and significant.
- December 31, 2026 End Date
While IRC §1031 exchanges allow for a continued deferral of both capital gain and depreciation recapture until either a cash-out event or a step-up in basis at the investor’s death, the original capital gain invested into the qualified opportunity zone fund is only deferred until December 31, 2026—albeit with a step up in basis of 10% or 15%, depending on the length of the investment.
- Exposure to Depreciation Recapture
For rental real estate-related gains invested into a QOZ fund, there may be exposure to depreciation recapture at a tax rate of 25% in the year the down leg real estate is sold even though the capital gain is invested into a QOZF.
- Tax-free Gains
Unlike a §1031 exchange, if the QOZ fund investment is held for 10 years, the profit from the opportunity zone investment may be taken tax-free. This does not mean that the tax liability from the invested capital gain in the opportunity zone is completely deferred, as at least 85% of that tax bill must be paid in 2026.
- Pass-through Entities
Unlike a §1031 exchange, the taxpayer who disposed of the relinquished property does not have to be the same one that acquires the replacement property in a QOZ fund. Thus, partners who receive gains from a pass-through entity may reinvest the gains as if they had received them directly. Furthermore, unlike in a §1031 exchange, investors in a QOZ fund have no 45-day identification window, and investors who are reinvesting gains from a partnership have 180 days from the end of the partnership’s taxable year, not from the date of the sale.
- Tax Bill
Lastly, it must be taken into account that the funds for paying the tax bill may still be invested in the Opportunity Zone in 2026, especially if the intention is to keep the investment for 10 years in order to achieve tax-free gains. Accordingly, investors may need to plan to cover their tax bill using other funds, unless there is a tax-free distribution from the fund from a loan refinance or a partial liquidation.
QOZ fund investment involves typical risks of traditional real estate investment, including illiquidity and concentration risks associated with local markets. Investors must read and understand all risk disclosures in the applicable full disclosure private placement memorandum (PPM) that would accompany any. Potential risks relating to each investment in a QOZ fund or a QOZ private REIT are disclosed in a private placement memorandum that must be read by the investor prior to making an investment decision. These risks include but are not limited to:
- Illiquidity (there is currently no secondary market);
- Tax status risk which may result in immediate tax liabilities, including penalties;
- The fact that substantial fees associated with the purchase of the investment may, in certain cases, outweigh the tax benefits;
- The risks of using leverage in real estate;
- The investment is speculative and involves a high degree of risk;
- The risks associated with fractionalized ownership in real estate and investment contracts as securities;
- Property appreciation is not guaranteed;
- The potential for loss of principal invested; and
- Other certain risks disclosed in detail within the Private Placement Memorandum should be reviewed before investing.
There are substantial risks associated with developing the Property in an economically disadvantaged, qualified opportunity zone that permits investors in the Fund to qualify for available Opportunity Zone Tax Benefits. There are tax risks associated with an investment in the Investor Units, including the possibility that government regulations regarding Opportunity Zone investments may change.
Diversification does not guarantee profits or protect against losses. Please note that the information above is for informational purposes. An offer to buy or sell or any solicitation can only be made to qualified accredited investors through a prospectus or private placement memorandum, which is always controlling and supersedes the information contained herein in its entirety. All investments have inherent risks. Potential risks relating to each investment are disclosed in a private placement memorandum that must be read by the investor prior to making an investment decision.
An investment in a QOZ fund involves a high degree of risk. You should purchase only if you can afford a loss of some or all of your investment. You should carefully consider the information set forth in “Risks” above and the corresponding section in the Private Placement Memorandum (PPM) of the particular offering that you are examining. This type of investment is not suitable for all investors.
Please also note that this opportunity is being presented to you based on your representation to us that you are an accredited investor. The Security and Exchange Commission defines an accredited investor as an individual with either $1 million in net worth (excluding the equity in your principal residence) or net income for the last two years of $200,000 or greater ($300,000 if accreditation is based on a married couple) with a reasonable expectation of such earnings in the current year. If you do not meet this definition of an accredited investor, please notify us immediately and disregard this message and its contents.
This does not constitute an offer to buy or sell any security. Investments in securities are not suitable for all investors. Investment in any security may involve a high degree of risk and investors should review all “Risks” before investing. Investors should perform their own due diligence before considering any investment. Past performance and/or forward-looking statements are never an assurance of future results. Investment products, Insurance, and Annuity products are not FDIC Insured/Not Bank Guaranteed/Not Insured by any Federal Government Agency/May Lose Value.
Securities are offered through WealthForge Securities, LLC 3015 W Moore Street, Suite 102, Richmond, VA 23230. Member FINRA/SIPC. Cornerstone Real Estate Investment Services is not controlled by or a subsidiary of WealthForge Securities LLC.