Opportunity Zones in Real Estate

As a physician, you may be frustrated by the amount of taxes you pay each year.  With a higher income comes higher taxes.  Most physicians focus on how to make more money but overlook ways to lower taxes.  However, taxes are a physician’s biggest expense and tax reduction is key to building wealth.

One way to reduce taxes is to invest in Opportunity Zones, which allows you to invest in underserved communities in need of revitalization and economic development, while also allowing you to defer, reduce or even eliminate eligible capital gains.  As such, investing in Opportunity Zones can offer an excellent blend of tax reduction and wealth creation.

What are Opportunity Zones?

Created by the 2017 Tax Cuts and Jobs Act, Opportunity Zones are lower-income census tracts designated by the federal government.  State governments were also able to choose 25% of the eligible census tracts in their states. There are approximately 8,700 designated Opportunity Zones within the United States, covering all 50 states, the District of Columbia and five U.S. territories.

Opportunity Zones provide a chance for investors to earn significant returns, while also gaining attractive tax benefits, including tax deferral, tax reduction and permanent tax exemption.

What is a Qualified Opportunity Fund?

A Qualified Opportunity Fund (QOF) is an investment entity, organized as a partnership or corporation, created for investing in Opportunity Zone investments.  A QOF must have at least 90% of its assets located inside an Opportunity Zone. 

To gain the tax benefits, you must place your money into a QOF and the QOF then invests in the property.  You cannot invest in a property directly.

To be eligible, a property must either be new construction, or if it is a rehab project, the QOF must invest equal or greater funds into property improvements than it did to initially purchase the property. 

Tax Benefits for Real Estate Investors

There are three main benefits to investing in Opportunity Zones: tax deferral, tax reduction, and permanent tax exclusion.

#1) Tax Deferral

Investors can defer paying existing capital gains if those gains are reinvested within 180 days of their sale into an Qualified Opportunity Fund.  This deferral is effective until the date that the investment is sold/exchanged or until December 31, 2026 (whichever occurs first).

Capital gains can be deferred from sales made outside of Opportunity Zones.  So investors who have any type of capital gains from the sale of an asset (including stocks, bonds, cryptocurrency, precious metals, real estate), can reinvest it in a QOF and benefit from the tax advantages.

#2) Tax Reduction

Investors who keep their money in an Opportunity Fund for at least 5 years will get a 10% step-up in tax basis (10% reduction in capital gain taxes).  Those who keep their investment in an Opportunity Fund for at least 7 years will receive an additional 5% step-up in tax basis (an additional 5% reduction in capital gain taxes).

To be eligible for the 10% step-up in tax basis, the investor needed to invest by December 31, 2021.  To be eligible for the additional 5% step-up tax basis, the investor needed to invest by December 31, 2019.  Due to the rule regarding recognition of gain no later than December 31, 2026, this tax reduction benefit is no longer available starting in the 2022 tax year.

#3) Permanent Tax Exclusion

Remaining in a QOF for at least 10 years results in the cost basis of the property being equal to the fair market value on the date of the sale/exchange.  Thus, investors who remain in an Opportunity Fund for at least 10 years won’t have to pay any capital gain taxes on the investment.

So in summary, Opportunity Zones are designed to incentivize long-term real estate investments by the following:

 

Length of Time in Opportunity Fund	Tax Benefit
<5 Years	Deferred payment of existing capital gains until date the investment is sold or December 31, 2026 (whichever is earlier)
5-7 Years	Above tax deferral benefits + 10% of tax on existing capital gains canceled
7-10 Years	Above tax deferral benefits  + 15% of tax on existing capital gains canceled
>10 Years	No capital gains tax on Opportunity Fund investment

An Example

Now let’s look at an example.  Say Dr. Jane purchased a duplex in her local market 10 years ago.  Over the years, she has built up quite a bit of equity and now wants to sell the property.  But she knows she will be faced with capital gains taxes.  Dr. Jane knows she can use a 1031 exchange to defer capital gains, but she is concerned about finding a “like-kind” replacement property in this competitive market and also wants to be more passive in her investments.

Dr. Jane calculates how much capital gain taxes would be deferred by investing her gains in an Qualified Opportunity Fund:

• Capital gains from selling duplex: $200,000
• By investing the $200,000 in an Opportunity Fund for 5 years, her taxable capital gain would be reduced by 10% ($20,000) to $180,000.
• After seven years, her taxable gain would be reduced by another 5% (for a total of 15%) to $170,000.
• After 10 years, any appreciation on her initial $200,000 invested would be completely tax-free.

Dr. Jane thinks about it.  If she invested her capital gains of $200,00 from the sale of her duplex into an Opportunity Fund and it doubled in value to $400,000 over the next 10 years, then she would have another $200,000 gain that would be completely tax-free.  She decides to sell her duplex and put her capital gains into an Opportunity Fund.

Opportunity Funds vs. 1031 Exchanges

A Qualified Opportunity Fund differs from a 1031 exchange in several ways.  First, a 1031 exchange can only be used with real estate assets, with the investor selling one piece of real estate and trading it for a replacement property.  

In contrast to 1031 exchanges, investing in Opportunity Zone Funds does not require the exchange of “like-kind” properties to qualify for deferred capital gains. The gain can be from stocks, cryptocurrency, businesses, art or any gain that could be recognized as a capital gain.  In addition, unlike a 1031, which requires all proceeds from the sale to be invested for full tax deferral, with a QOF, only the gain needs to be reinvested in a Qualified Opportunity Fund.

Below are some of the key differences between a 1031 exchange and an Qualified Opportunity Fund:

 

	1031 Exchange	Qualified Opportunity Funds
Asset Type	Real property only	Any asset (real estate, stocks, bonds, art, businesses, precious metals, etc.)
Required Investment	Entire proceeds from sale	Only capital gains, in any amount
Investment Timeline	45 days to delegate a replacement property & 180 days to close	180 days to contribute capital from sale of the property
Where to Invest?	Anywhere in the U.S.	Must invest in a Qualified Opportunity Zone
Ownership	Ownership of new property must be same as owner of old property	Owner of new property must be Qualified Opportunity Fund
Intermediary Required?	Yes	No

Conclusion

Investing in Opportunity Zones allow physician-investors to invest in economically stagnant communities and spur on revitalization, with the potential for strong returns and ability to reap significant tax benefits.  But as with any other investment, it’s important to assess the risk and rewards before investing in Opportunity Zones.