Is Investing In An Opportunity Zone Right For You?


Horacio Gallegos

In an attempt to stimulate economic recovery in certain regions across the country, the U.S. Congress formed the Opportunity Zone program with passage of the 2017 Tax Cuts and Jobs Act.


What is an opportunity zone?

It’s a census tract that’s made up of economically distressed areas that meet the following requirements.:

  • The census tract must have a poverty rate of at least 20 percent OR a median family income of:
    • 80% or less of the median family income for non-metropolitan areas within the state
    • 80% or less of the statewide median income or the overall metropolitan median family income for metropolitan areas

To be designated an opportunity zone, Governors from each state nominate up to 25% of census tracts that meet the above criteria. Also, another 5% of each region could be named an opportunity zone if they:

  • Are contiguous with a low-income opportunity zone and
  • Have a median family income up to 125% of the median income level of the opportunity zone adjacent to it

Using these criteria, the Brookings Institute has noted that 57% of all neighborhoods across the country can be considered opportunity zones!

In addition to the fifty states, opportunity zones have also been designated in:

  • District of Columbia
  • American Samoa
  • Guam
  • Northern Mariana Islands
  • Puerto Rico
  • Virgin Islands


Opportunity Zone Fund

An opportunity zone fund is the investment vehicle which investors can use to participate in the opportunity zone program.

For an opportunity zone to be qualified it must be either a US partnership or corporation which has indicated its intent to invest at least 90% of its holdings in one or more opportunity zones.

The law puts certain restrictions on the investment types that the fund can invest in to ensure that the investments stimulate growth within the communities they’re targeting.

These are known as Qualified Opportunity Zone properties and are defined as follows:

  • Partnership interests in businesses operating in a qualified opportunity zone
  • Stock ownership in businesses that operate most or all of their business within a qualified opportunity zone
  • Real estate that is situated within a qualified opportunity zone

Note that in the case of real estate, it needs to be either new construction or an existing structure whose renovation costs exceed the costs to purchase it.

Whether newly built or renovated, the building development must be finished within 30 months of purchase to be eligible for participation in the fund.

Note: Certain types of businesses are disallowed from qualifying as an opportunity zone (e.g. country clubs, massage parlors, golf courses, etc.).


How commercial real estate investors benefit

Commercial real estate investors can enjoy huge tax advantages both immediately and over the long term by investing in opportunity zones.

Here’s how…

When you reinvest the capital gain you’ve received through an investment you have 180 days to reinvest that money into a Qualified Opportunity Fund (QOF). This allows you to defer and reduce your tax liability on any gains you’ve acquired.

There’s also the potential to keep – tax-free – any appreciation you’ve gained through your investments in the fund.

Note that unlike other tax incentives, such as the 1031 exchange, investors can roll over capital gains from investments other than real estate.

This is a huge benefit for investors to save on gains from other classes of investments in addition to their tax savings on real estate.


How it works

Investors who realize capital gains have 180 days from time of receipt to roll them over into an opportunity fund.

This allows investors to defer paying tax on their capital gains as follows:

  • Investors can defer gains until December 31, 2026. Then a reduced percentage of taxes would be payable by April 2027. The amount due would depend on when investors began to invest in the opportunity zone fund
  • If investing 5 years prior to December 31, 2026, their tax liability will be slashed by 10 percent
  • After 7 years this number jumps up to 15%
  • If the investment into the qualified opportunity zone is held for 10 years, there is ZERO tax liability on the gains from the opportunity zone investment

As you can see, to enjoy a fifteen percent reduction on your initial capital gains you need to invest in an opportunity zone this year.

In addition, if you maintain your investment in the opportunity zone for ten years or more you will pay zero capital gains should you choose to liquidate.


Who can create an opportunity fund?

To meet the unique needs of distressed communities, the law allows for a range of entities to create an opportunity fund. Assuming they comply with the rules and regulations of the statute and the Fed, any of these parties can set up an opportunity fund:

  • Community development entities
  • Venture capital investors
  • Developers
  • Regional Economic Development organizations
  • Individual taxpayers


How is a qualified opportunity fund (QOF) created?

It’s simple to create an opportunity fund.

Any eligible taxpayer can complete IRS Form 8996 and submit it with their federal income tax return for the taxable year.

Note: A qualified opportunity fund must maintain at least 90% of their assets in qualifying zone property. Compliance will be tested mid-way and at the end of the year.


Prevention of abuse

As an investor, you can’t just put your money in real estate in an opportunity zone and let it sit as you’re required to substantially improve the property in an effort to invest in improving the economic conditions of the community.

The Treasury Department has the authority to enact rules and regulations to prevent abuse of this tax reduction incentive including levying penalties for violations.


Available opportunity zones in Texas

There are 628 designated opportunity zones in Texas, and all of them are in low-income areas. No non-low-income contiguous tracts were categorized as opportunity zones.

While only 16 percent of Texas’ census tracts have been designated rural, 30 percent of the opportunity zones in Texas are in rural areas.


Investment structure

As noted earlier, to invest in an opportunity zone it has to be done through a fund.

And that fund has to have a structure, such as a corporation or a partnership, and 90% of its assets must be in a qualified opportunity zone.

This can mean real estate, another corporation or tax partnership that manages a qualified opportunity zone business, or it invests in the qualified assets of that business directly.

Remember…if you’re investing in a qualified opportunity fund you hold an interest in the fund itself, not the property that the fund owns.

Also, not every property is eligible for a fund to invest in…it must invest either directly, or indirectly in an income-producing business that’s within a qualified opportunity zone.

 

What a QOF cannot invest in

Examples of businesses that a qualified opportunity fund cannot invest in includes so-called “sin” businesses such as:

  • Private and commercial golf clubs
  • Tanning salons
  • Country clubs
  • Gambling facilities
  • Massage parlors
  • Hot tub facilities
  • Liquor stores
  • Racetrack

Note: The legislation for allowing qualified opportunity zone fund investment in businesses within the cannabis industry is still being worked out.

While the statute does preclude the investment in businesses that are operating in the industries noted above, it’s still allowed for an opportunity zone fund to start such a business itself.


How to invest in Texas designated opportunity zones

Think about how you’d like to invest your capital.

If there’s a particular community or region that’s important to you, the best way to find opportunity zones – if you don’t create one yourself – is to look for economic development councils in the area you’re interested in.  Experienced real estate development and investment firms may also have the knowledge and experience to assist you in investing in a opportunity zone.

Many organizations have websites with lots of information about how to get started.

While you have a little time – 180 days – to move your capital gains, the sooner you know where you want to move it, the better because it can take a little time to shift the funds.

As usual, when investing in opportunity zone funds it’s important to exercise your due diligence to ensure that you’re investing in a good opportunity.

Ask the following questions before choosing a particular qualified opportunity fund:

  • Is the management team qualified?
  • What are the expenses?
  • What type of assets is the fund investing in?
  • Does this make sense? Would I invest in this whether or not I got a tax break?

Finally, it’s important to note that much of the rules and regulations surrounding investing in qualified opportunity zones is still in flux, so we may see more changes come about over time.

Bottom line, this tax incentive still remains a very good option for commercial real estate investors searching for ways to reduce their tax, but like any investment, it’s important to do your due diligence to determine if it’s right for your situation.