A Qualified Opportunity Zone Fund (“QOZ”) is an investment program created for the purpose of investing in “qualified opportunity zone property”, located in distressed and/or low-income areas and targeted for economic revitalization.
Investing in a QOZ generally offers three potential tax benefits to investors:
An investor may elect to defer tax on capital gain from the sale or exchange of property with an unrelated person by investing the gain as equity in a QOZ within 180 days after the sale or exchange. The deferral ends on December 31, 2026, or sooner if the investor sells her interest in the QOZ, at which time the investor must recognize the gain with respect to the original property
2 Partial Step-Up
If the investor holds her interest in an opportunity fund for five years, she can step up her basis in the QOZ by an amount equal to 10% of the deferred gain with respect to the original property and, if she holds her interest in the QOZ for seven years, she can step up her basis in the QOZ by an amount equal to an additional 5% of the deferred gain, for a total 15%. This reduces the amount of recognized gain at the end of the deferral period.
3 Larger Step-Up
If the taxpayer holds her interest in the QOZ for at least 10 years, she can step up her basis in the QOZ to the fair market value of her interest on the date the interest is sold. This enables the investor to eliminate income tax on any post-acquisition capital gain in her QOZ interest, including any capital gain attributable to leverage incurred by the fund.
Recent attention to QOZs has drawn comparisons between QOZs and 1031 exchange programs like DSTs. While both strategies certainly have tax benefits, our clients should consider several factors when deciding between investing in QOZs and real estate programs that qualify for 1031 exchanges. Of course, there may be circumstances when simply paying taxes makes the most sense for an investor.
As in any real-estate based investment, it is important to examine the fundamentals of the underlying real estate, regardless of whether the properties are inside a DST, QOZ, REIT or limited partnership. At 1031 Capital Solutions, our in-house due-diligence team thoroughly vets every approved program, and we take the process even further by seeking to find that a given program is reasonably suitable for a prospective investor.
Some considerations, amongst others, for QOZs include:
- Track record of the developer
- Demographics in the target property market
- Economic, population and employment trends
- Supply and demand for the proposed project
- Status of the project in the entitlement and financing process
1031 exchange: must reinvest all proceeds to defer all taxes.
QOZ: only the gain must to be reinvested to receive tax benefits.
1031 exchange: 45 days to identify, 180 days to close, must use a qualified intermediary (QI) to hold the funds throughout the exchange (see our tab on this site, The 1031 Process).
QOZ: do not require a QI, up to 180 days to reinvest the gain; may be a potential backup in the event of a failed 1031 exchange.
1031 exchange: no limits on the number exchanges, deferral possible until death.
QOZ: only a temporary deferral and will recognize a capital gain on or before December 31, 2026.
1031 exchange: well established, with hundreds of DST programs sponsored under IRS guidelines issued in 2004
QOZ: new and developing rules and regulations.
DST: established occupied properties, typically seeking to produce immediate cash flow
QOZ: development projects that generally will not generate cash flow for the first 2-4 years; may have higher potential IRRs than existing DST properties.
DST: investors should plan for 10 years, but programs may liquidate in five to seven years.
QOZ: minimum hold period of 10 years.