In June, I wrote about Opportunity Zones, a new program that looked to be the best investment opportunity since Google. It turns out, things are less promising than they originally appeared unless you fit into a very narrow band of real estate investors.
Please! This is one investment opportunity where you MUST talk to your attorney and accountant before you undertake any action.
As a brief refresher, in December 2017, the federal government passed a tax bill that paved the way for a new program to encourage investment in low-income communities by creating Qualified Opportunity Zone (QOZ). QOZs correspond with census tracks and are designated by the state based on average income levels, and my understanding is that much of the Ukiah Valley is a QOZ.
It works like this. Investors reinvest capital gains by funding a Qualified Opportunity Fund (QOF) and then developing an investment property in a QOZ, thereby delaying or reducing their tax burden. Unfortunately, the restrictions are so onerous that few investors are likely to jump in.
Here’s why. Investors who own assets with significant accrued capital gains can sell the assets and reinvest the capital gains portion of the proceeds in a QOF. That fund can then be used to acquire real estate inside a Qualified Opportunity Zone, delaying the tax on the reinvested capital gains through December 2026, and ultimately completely avoiding capital gains on the appreciation of the acquired property.
That all sounds fantastic, except that almost none of us qualify. Here’s the fine print.
- Only the portion of the investment paid for with capital gains from a prior investment earns the tax benefit.
- You cannot do a 1031 Exchange (read my prior column on this topic for more information) because the capital gains must first be deposited into a Qualified Opportunity Fund before being invested in real estate.
- With a 1031 Exchange, you’d be able to defer tax on the original capital gains for an extended period of time, maybe forever with aggressive estate planning. With the Qualified Opportunity Zone, you must realize the gain on the sale of the original asset in December 2026, when you will owe taxes on the gain, even if you don’t liquidate the property. Fun fact: to achieve maximum tax benefits and avoidance of gains on appreciation, you must hold the property for a minimum of 10 years—even though a portion of the tax bill comes before that. After holding the property for five years, you eliminate 5 percent of the gains on the acquired asset sale. After seven years, you eliminate 15 percent of the gains on the acquired asset sale. It’s not until you hold the property for 10 years that you eliminate 100 percent of the gains on the acquired asset. This means, if you liquidate in December 2026 to pay those taxes on the original capital gains, you’ll lose the vast majority of tax benefit the program was designed to provide.
- This program also requires that within 30 months, you must double the basis in your acquired property. If you buy real estate in the QOZ for $500,000, you must invest an additional $500,000 to improve the property. Basically, this means you need to buy raw land and build on it or buy a massive fixer-upper—and get the building project completed in 30 months. This may be difficult!
The Department of Treasury says changes to the rules are coming, so we’ll see, but at this point, I’d stick with 1031 Exchanges where taxes on the original asset can be deferred indefinitely (along with tax on the appreciation). If, by some quirk of fate, you recently sold assets and are about to get hit with a huge capital gains tax bill and you’ve been wanting to get into real estate development, then by all means, look into the Opportunity Zone program.
If you have questions about real estate or property management, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.