Every real estate investor needs to find at least one way, and preferably several, to gain an advantage in the market. One of the largest potential advantages is an opportunity zone (OZ). If you’re unfamiliar with this particular benefit, here’s why you might want your next property to be in this particular type of zone.
What is an Opportunity Zone?
Created by the Tax Cuts and Jobs Act of 2017, opportunity zones are designated low-income, economically distressed communities where new investments may be eligible for substantial tax incentives.
These zones were specifically crafted to spark economic growth and job creation in underprivileged areas, injecting fresh vitality and opportunities for residents, while also offering investors a potentially profitable and socially responsible investment avenue.
Having a designated zone encourages investment and development where it’d otherwise be challenging and risky, if not downright financially unfeasible.
An investment generally must benefit the community where it’s located in a certain way to qualify for the benefit. Investments are made into a Qualified Opportunity Fund (QOF).
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Pros and Cons of Investing in Opportunity Zones
Opportunity zone investments, like any commercial real estate program, have a unique set of potential advantages and disadvantages that must be assessed before pursuing this benefit.
Benefits of Investing in Opportunity Zones
Investing in opportunity zones presents multiple benefits. Some of the most compelling include:
- Tax Incentives: Investors can defer tax on prior gains until December 31, 2026, as long as the gain is reinvested in a Qualified Opportunity Fund (QOF). If the investment in the QOF is held for longer than five years, there is a 10% exclusion of the deferred gain, which increases to 15% if the investment is held for more than seven years. If held for at least ten years, they may qualify for an increase in the investment’s basis equal to its fair market value on the date it is sold—resulting in no taxable income for any appreciation over the investment’s lifetime.
- Potential for Economic Growth: By contributing to the revitalization of economically distressed communities, property values can rise considerably, offering the potential for high returns.
- Social Impact: Investors have the opportunity to positively influence communities by creating jobs and fostering economic development. The do-good nature is a nice side benefit for any investor regardless of focus, but it’s especially important to investors who follow environmental, social, and corporate governance (ESG) investment strategy.
Risks of Investing in Opportunity Zones
Despite the attractive benefits, investing in opportunity zones also comes with its share of risks:
- Investment Risk: Due to the economically unstable nature of these zones, investments may be risky and may lead to lower returns or even losses. The tax incentives are intended to help mitigate this to a significant degree, but they don’t eliminate all risks that accompany projects in higher-risk areas.
- Potential for Gentrification: Investment in these zones may inadvertently lead to gentrification, potentially displacing long-time residents and disrupting the social fabric of the community. This may be an ESG consideration, but it also can result from localized pushback against the planned project.
- Regulatory Risks: The regulatory landscape surrounding opportunity zones is complex and can evolve, which can lead to potential legal and compliance risks. Investors and the professionals they work with (e.g. agents, attorneys, etc.) may choose to specialize in these investment opportunities so that they know the regulations well.
How to Invest in Qualified Opportunity Zones
Investments in opportunity zones are made via a Qualified Opportunity Fund (QOF), a specialized investment vehicle set up as a corporation or partnership. It’s designed to invest at least 90% of its assets in eligible property located in a designated opportunity zone.
Criteria and Eligibility to Invest in Opportunity Zones
Most commercial real estate investors qualify for a QOF, and therefore an opportunity zone investment. The biggest criteria are the location of the property and the corresponding use of the fund. This isn’t to say that all investors should take advantage of this, though.
The opportunity zones program is ideally suited for investors with significant capital gains from a recent transaction. These capital gains can be reinvested into a QOF within 180 days of the sale or exchange that generated the gains, and the investor can then benefit from the tax incentives offered by the program.
It’s also normally recommended that investors have a 10-year horizon so they can take full advantage of the tax benefits.
What is a Qualified Opportunity Zone Fund?
The QOF plays a pivotal role in the opportunity zones program. It serves as an investment conduit, specifically structured to invest at least 90% of its assets in qualifying properties within opportunity zones. These funds enable private investors to pool their resources to support investments in these distressed regions.
How to Find Opportunity Zones
Opportunity zones are located across the U.S., in both urban and rural settings. Tools such as the U.S. Department of the Treasury’s Opportunity Zone Resources, which includes an interactive map, provide detailed information on all designated zones. This map is the easiest place to begin gathering information.
A state’s economic development branch can also be a great source of state-specific information.
Where are Opportunity Zones Located?
Spread across all 50 U.S. states, the District of Columbia, and five U.S. territories, opportunity zones are a national initiative. State governors have identified these zones, which were subsequently certified by the U.S. Treasury Department. They include a broad range of areas, from urban neighborhoods that have been overlooked by investors to rural areas needing economic stimulus.
Investing in opportunity zones offers a unique blend of financial and social benefits, providing investors with substantial tax incentives while simultaneously fueling the economic revitalization of distressed communities. That said, it’s crucial for investors to consider the associated risks and regulatory requirements carefully before pursuing this program. Consider your overall investment strategy, knowledge, and portfolio to determine whether you should use an opportunity zone to gain an advantage.