By now, most active investors in real estate have at least heard the term “opportunity zone” (OZ) even if they aren’t completely clear on what it is or the advantages this incredible program provides. An OZ is an economically distressed community in which new investments may be eligible for preferential tax benefits. These areas have been nominated by their governors and approved by the secretary of the U. S. Department of the Treasury to spur economic development, creating jobs and improving neighborhoods.
OZs were created and added to the tax code on Dec. 22, 2017. Originally, they were only offered in 18 states, but they’re are now available in all 50 states, the District of Columbia and five U.S. territories. Investors and developers can seek properties in these areas with the intent to renovate and repurpose, generally for a long-term hold (10 years minimum).
How It Works
To invest in a qualified opportunity zone (QOZ), you must first create a qualified opportunity fund (QOF). The vehicle can be a partnership or a corporation, or a limited liability company if treated as a partnership or a corporation for tax purposes.
The good news is, at the time of this writing, investors can self-certify by filing QOF Form 8996 with their federal income-tax return. The main advantage is you don’t have to wait for IRS approval. Simply fill out the form, attach it to your return and you’re done. Note: Hire an attorney with experience in forming QOFs and coordinate his efforts with your certified public accountant to ensure you’re in compliance.
A QOF must invest 90 percent of its assets in a QOZ. These can be in the form of corporate stock or partnership interests in a business that’s in the OZ, or tangible property in the QOZ.
The reason so many people are excited about this incredible gift from the federal government is when you invest in an QOZ, you can separate the base from the gain. For example, if you sell a $300,000 property in which the base was $200,000 and the gain is $100,000, you can keep the $200,000 base and reinvest the $100,000 gain into the QOF. This way you can defer the taxes.
OZs can be identified at cdfifund.gov, the Community Development Financial Institutions Fund page for the U.S. Department of the Treasury. If you don’t see any in your area, you still might be able to find one somewhere that works for your investing strategy.
Understanding the Benefits
There are several benefits to investing in an OZ. The first is tax deferment. Investors can defer the tax on any prior gains invested in a QOF until the date on which the investment is sold or exchanged, or Dec. 31, 2026, whichever comes first. The new law gives you 180 days to reinvest your gains. So, if you sold a self-storage facility in April 2019, you’d have approximately six months to reinvest that money into a QOF, and you could then defer paying taxes on the gain until December 2026—that’s nearly seven years!
As great as that is, it isn’t even the best part. The longer you hold your investment in the QOZ, the better the benefits. Let’s say you purchase a property and hold it for at least five years. You’ll be eligible to increase your basis by 10 percent. That portion of your gain will be forgiven and only 90 percent of your original gain is taxed. If you hold for at least seven years, your basis is increased by 15 percent, meaning only 85 percent of your original gain is taxed. But the real beauty of investing in an QOZ is if you stay for 10 years, you’re allowed to increase your basis to the fair market value of the investment on the date it is sold. This wipes out any additional gains on the appreciation of the property!
For example, let’s say you invested a $250,000 gain into a QOF that then invested in a small self-storage facility. After five years, you’d only be taxed on $225,000. After seven years, you’d only be taxed on $212,500. At 10 years, the facility is worth $850,000 and it’s time to sell. Instead of a gain of $600,000 from appreciation, you have a zero gain based on the appreciation basis increase, and you won’t have to pay taxes on $637,500.
The only thing you must do to take advantage of one of these opportunities is invest a recognized gain in a QOF and elect to defer the tax on it. A recognized gain can be any kind, whether from the sale of real estate, stocks, artwork, mutual funds, etc. Though it must be reinvested into the QOF within 180 days of the sale or exchange, there’s no limit to the amount of gain that can be invested into the fund.
In the past, to defer the taxes on a gain, it had to be reinvested into a like-kind investment—real estate into real estate, stocks into stocks, and so on. That isn’t true with a QOF. For example, someone who’s been thinking about getting into real estate with gains from the stock market now has a chance to do so.
Doing Your Homework
As you review the OZ maps, keep in mind you still must perform due diligence on the acquisition of an existing facility. On any conversion or new development project, you must employ a feasibility consultant before you get too excited. What you may begin to see is many deals that didn’t look good on the surface suddenly become attractive when you factor in the savings this opportunity provides. When creating your projections, however, just remember that depressed neighborhoods come with a few more operational challenges.
I recently realized a 40 percent savings on the back end of a site I acquired with equity in the form of “gains” from a previous project. I then rolled it into a QOF and invested in a conversion project I plan to hold for 10 years to get the maximum benefit.
Can OZs help you build your self-storage empire a bit faster? As investors, we want to take advantage of as many resources as possible to reduce expenses, the most expensive of which is always taxes. No surprise, the introduction of the OZ program has mobilized investors to snap up projects to hold for 10 years or more. It’s one of the most powerful tools for creating wealth in real estate and self-storage!
Scott Meyers, founder of Self Storage Profits Inc., has been involved in the self-storage industry as a developer, owner, syndicator and operator since 2005. He owns and operates 22 facilities in nine states. His community, www.thestoragemastermind.com, consists of equal parts owner/developers and private-equity investors who partner on select projects nationwide. To reach him, e-mail firstname.lastname@example.org; or visit www.selfstorageinvesting.com.