What is a Qualified Opportunity Zone

Summary/TL;DR

A Qualified Opportunity Zone (QOZ) is a real estate investment made in a distressed area that qualifies for preferential tax treatment. When a QOZ is a commercial multifamily real estate property, it stands to only improve upon the almost unbelievable tax and investment potential of such investments. If an investment in a QOZ is properly funded and held for a minimum of 10 years, there are no gains or recaptured depreciation to be subject to capital gains tax. Before investing in a QOZ, you need to ensure that you are prepared to take full advantage of the tax advantages, have plenty of liquidity, and are comfortable with the track record of the property sponsor.

Introduction

The IRS defines a Qualified Opportunity Zone (QOZ) as an “economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” Properties that qualify as QOZs are commonly multifamily real estate complexes that present investors with very attractive income and capital gains potential. Where QOZs really shine, however, are their tax-advantages. In fact, I would go so far as to say that QOZs might be the most tax-efficient investment that one can make in the current legislative environment.

Commercial Multifamily Real Estate In General

QOZ or not, I consider a sound investment in a commercial multifamily real estate property to be amongst the gold-standard of wealth-builders.

These properties will provide their owners with passive income, which is often received tax-free due to depreciation and other expenses related to running the property. Furthermore, when the properties are refinanced, all the equity taken out and returned to investors is received tax-free. When the property is a true “value-add” property and is purchased by a knowledgeable and competent investor (like this guy), refinancing can present a tremendous opportunity. Finally, when the property is sold, gains can be deferred into a new property via a 1031 exchange. When these properties pass to the next generation, the basis receives a “step-up”, essentially eliminating the taxes on any deferred gains. If, however, the gains are not deferred via a 1031 exchange, then any capital gains and depreciation taken over the time you owned the property will be subject to tax.

Does all this sound unbelievable? Just wait until we discuss QOZs in the section below.

The Tax Advantages of Qualified Opportunity Zones

All the investment and tax characteristics of commercial multifamily real estate described above are also characteristic of QOZs that are multifamily complexes. As mentioned above, when a non-QOZ property is sold, however, capital gains tax is due on the growth of the property, and any depreciation taken over the life of the property is also “recaptured” and included in this taxable gain. If a 1031 exchange is not appropriate, the investor is left holding the tax bill. QOZs, however, are treated very differently.

If an investment in a QOZ is funded with qualified capital gains and is held for a minimum of 10 years, then there are no capital gains due upon the sale of the property and no depreciation recapture! Suppose, for example, that you made a $500,000 investment in a non-QOZ property. Over the life of the property, you’ve taken $250,000 in depreciation, so your basis is $250,000. When the property is sold, your shares are valued at $1,000,000, leaving you with a $750,000 taxable gain and a $150,000 tax bill. During this time, you would have collected a fair amount of tax-free income, and the depreciation would have helped offset other passive income you might have had, but this $150,000 tax bill still hurts!

Clearly, QOZs make a great investment even better!

Common Mistakes When Investing in Qualified Opportunity Zones

By far the biggest mistake you can make when investing in a QOZ is to do so within a Traditional IRA. Doing so will nullify all the tax advantages we outlined above and is actually inferior to holding the property outside of an IRA from a tax perspective. While investing through a Roth IRA is better, it still blunts some of the tax advantages of a QOZ since growth in a Roth IRA is tax-free no matter what the investment is. To make the most of a QOZ, you want to invest with assets held outside of an IRA that would otherwise be subject to taxation if they were invested in anything else. In fact, as mentioned above, purchasing a QOZ with funds that are currently subject to capital gains tax is the only way to realize its full tax benefits.

Furthermore, you’ll want to be sure that you don’t need the money you invest in the QOZ for a long time. I briefly mentioned above that the QOZ must be held for a minimum of 10 years before being sold to qualify for the tax advantages. Clearly, then, you need to be sure that you have plenty of liquidity in other investments before investing in a QOZ.

Finally, you need to be sure that the property sponsor – the one raising the capital to purchase the property and is responsible for managing it – is highly competent and has experience investing in these types of properties. What is their buying criteria? How many deals have they done? How have they performed? How do they plan to add value to and manage the property to be able to raise rents in the future? Are they holding the property beyond the 10-year period required for the QOZ or not? Are they having a cost-segregation study completed and passing depreciation through to the limited partners? How much do they, personally, have invested in the deal (it should be a lot!)? Having the answers to all of these questions (and many more) are extremely important before making an investment of any type like this.