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Opportunity Funds were introduced by The Tax Cuts and Jobs Act, and are designed to revitalize select low-income communities, called Opportunity Zones, through tax advantaged private sector investments.
In this post, we discuss Opportunity Funds, their powerful tax benefits, and how real estate investors can take advantage of this section of the tax code.
What are Opportunity Zones?
Opportunity Zones are low-income communities nominated by state governors and approved by the US Treasury.
What are Opportunity Funds?
Opportunity Funds are investment vehicles, structured as partnerships or corporations, which invest 90% or more of their assets in Opportunity Zones.
These funds are designed to revitalize Opportunity Zones through private sector investments by providing investors with powerful tax incentives.
What are the Tax Incentives of Opportunity Funds?
Opportunity Funds are similar to 1031 Exchanges because investors can defer the capital gains tax on the sale of capital assets (i.e. stocks, real estate, etc.) by investing the proceeds in a Qualified Opportunity Fund within 180 days from the sale.
Investments held in Opportunity Funds for:
- 5 years receive a 10% basis increase in the original investment.
- 7 years receive an additional 5% basis increase, bringing the total basis increase to 15%.
Investors also receive a permanent tax exclusion on capital gains generated by Opportunity Fund investments when the investment is held for at least 10 years.
You purchased $100,000 of XYZ Co. stock in 2010. In 2018 you sell the stock for $250,000, generating a capital gain of $150,000. And within 180 days you invest the capital gains in an Opportunity Fund, deferring the capital gains tax.
In 5 years, the basis in your original investment of $100,000 increases by 10% to $110,000, which reduces your capital gain by $10,000. And in 7 years your basis increases another 5% to $115,000, which reduces your capital gain by a total of $15,000.
But you’re not done. You hold the investment for 10 years. And during this time, your $150,000 investment in the Opportunity Fund appreciates to $250,000, generating another $100,000 capital gain. Because you held the investment for 10 years the capital gains tax on your Opportunity Fund investment is eliminated.
To recap – You started with an investment of $100,000 which turned into $250,000, resulting in a total gain of $150,000. You then rolled the $150,000 gain into the Opportunity Fund. Now you’re only paying capital gains on $135,000 ($250,000 - $115,000) of that gain because your basis in the original investment increased by $15,000. Plus you held the investment in an Opportunity Fund for 10 years, which eliminated the tax on the $100,000 ($250,000 - $150,000) capital gain generated from the fund.
How Real Estate Investors Can Take Advantage of Opportunity Funds
Opportunity Funds must invest in “Qualified Opportunity Zone Business Property” that either originate with the fund, or was substantially improved by the fund.
Substantially improved means there are additions to the property's basis that exceed the adjusted basis during any 30 month period after the property was purchased. For example, if you bought an old apartment building with an adjusted basis of $100,000, you would have to add over $100,000 to the property’s basis during a 30 month window.
This gives real estate developers, syndicates, and funds the opportunity to not only assist in the revitalization of low-income communities, but also provide investors with tax advantaged investment opportunities.
A few investment strategies include:
- Development of affordable workforce and low-income housing
- Redevelopment of abandoned office buildings or retail shopping centers
- Redevelopment of existing buildings to provide safe and affordable housing
And if you're a passive investor looking to diversify your portfolio into real estate, this gives you the opportunity to sell a portion of your current portfolio (i.e. stocks or mutual funds). Then defer the capital gains tax, and reinvest the full proceeds into an Opportunity Fund.
The Bottom Line
Opportunity Funds provide real estate developers, syndicates, and funds the opportunity to profit from the revitalization of low-income communities. And since they provide some pretty powerful tax benefits to passive investors, there should be no shortage of capital to fund these deals.
However, there are still many unanswered questions regarding exactly how these funds will work. But, it is expected that the first funds will set the precedent for subsequent funds, and the US Treasury and IRS will provide further guidance as time goes on.
To get the full scoop, and latest updates, on Opportunity Funds check out The Real Estate Investor’s Guide to Opportunity Funds.