The tax benefits of investing in a qualified opportunity fund
Investors who have eligible capital gains, which could be from the sale of stocks, real estate, businesses, or other investments earned before Jan. 1, 2027, can roll their qualified gains into a qualified opportunity fund. Investors have 180 days or less from the realized gain to elect their eligible gain by filing Form 8949 as well as Form 8997, which provides them the opportunity to benefit from the following tax incentives:
- Any tax on capital gains placed into a QOF, regardless of how long the investment is held, is able to be deferred until the investment is realized or sold on Dec. 31, 2026, whichever is sooner.
- If qualified capital gains are invested in a QOF for five years or more, capital gains on the original cost basis is reduced by 10%.
- If the investment is held for seven years or more, the cost basis for the original capital gain is reduced by 15%.
- If the investment is held for 10 years or more, the investor benefits from the 15% cost basis reduction of the original capital gain, in addition to paying zero capital gain tax on the new investment appreciation, which is any returns earned from the opportunity zone investment specifically.
The takeaway: The longer the investments are held in the OZ, the greater the benefit to the QOF and its investors.
How to invest in a qualified opportunity fund
Most investors choose to passively benefit from the tax incentive described above by placing their qualified capital gains into an established QOF. The QOF manages the investments, providing a specified return to their participating investors as outlined in the initial capital commitment agreement.
Investors can find a list of qualified opportunity funds from the National Council of State Housing Agencies (NCSHA) Opportunity Zone Fund Directory, which allows you to filter the funds by investment focus, fund size, or geographic focus. Keep in mind that each fund will have its own requirements for investor participation, which could require investors to be an accredited investor or meet varying minimum investment requirements.
How to start a qualified opportunity fund
Active real estate investors with extensive experience managing real estate investments in the residential or commercial sector may choose to become or create a QOF. Creating a real estate hedge fund can be a complicated, expensive task, so it's generally something only experienced investors take on. Technically, partnerships, limited liability companies (LLC), or corporations can elect to become a qualified opportunity fund by filing Form 8996 each taxable year.
From there, it's up to the fund's management team to ensure they're following the final regulations outlined by the IRS to maintain the designation of a QOF. This includes meeting the 90% investment standard for qualified opportunity zone property or 50% income threshold for QOZ business, which is assessed every six months, starting on the last day of the first six-month period of the tax year, or the last day of the tax year, whichever falls first for any real property held.
Any assets acquired must be already established as operating properties or businesses in the OZF, or if abandoned or not developed yet, must have substantial improvements made to the property within 30 days from acquisition. Failure to meet these requirements can result in penalty.
Pros and cons of investing in opportunity zone funds
Opportunity zone funds offer major potential, such as tax incentives and breaks to participating investors, all while helping economically challenged communities. However, choosing the right investment vehicle and market are key to a successful investment. With over 8,700 different census tracts to potentially invest in, fund managers must identify the markets that hold the most opportunities while providing the most stability and security, given the nature of investing in economically depressed areas. Those who choose wisely can be handsomely rewarded.
Eligible investors who have or will have significant capital gains that would benefit from tax deferral or capital gain reductions should carefully consider investing in an opportunity zone fund. The tax benefits are tremendous, but only for the patient investor. Since investments require a minimum five-year investment, money placed into a qualified opportunity zone fund is somewhat illiquid until the fund's disposition or capital structure is completed.