Sometimes we don’t recognize a good thing until it is gone. For most, that is turning out to be the case with Qualified Opportunity Funds (QOFs). Often misunderstood and underutilized, QOFs provide a tremendous opportunity for long-term tax-free growth of wealth, similar to a ROTH IRA.
Opportunity Zones were created through the Tax Cuts and Jobs Act of 2017; a brainchild of a Silicon Valley entrepreneur, Sean Parker who made his fortune developing Napster, Spotify, and Facebook as well as some proactive socially responsible Senators Cory Booker and Tim Scott with Representatives Ron Kind and Pat Tiberi.
In order to fully understand QOFs, we should look back on the original proposal and timeline of events. In the mid 2000’s, Sean was sitting on some impressive capital gains from tech ventures and felt compelled to give back to his community. With friends in high places, he worked with the Senators and Representatives to come up with a concept that would infuse capital into neighborhoods needing a helping hand, while incentivizing those fortunate to have capital gains of any kind to put those profits to good use. It took several years to iron out, but in 2017, Qualified Opportunity Funds were born, and the private sector began plotting its investment strategy.
Each state was allotted a certain percentage of their geography to designate as Opportunity Zones (OZs) by their governor. The stipulation was that they had to fall within low-income community census tracts. About 10% of the United States is currently deemed an Opportunity Zone.
Understanding Tax Incentives
With the objective to help underprivileged communities, they wanted to ensure that this was not just a money grab for wealthy hedge fund managers and private equity firms, so the incentives were structured to require long-term commitment. They are as follows:
Any capital gain rolled into a Qualified Opportunity Fund within 180 days of the transaction would be deferred and realized on December 31, 2026.
A step-up in cost basis would be provided on capital gains; 10% if held in the QOF for a minimum of 5 years, and an additional 5% (total of 15%) when crossing the 7-year mark. Based on the deferral period ending in 2026, those step-up benefits have sunset and are no longer available.
Capital invested that remains in a QOF for a minimum of 10 years would not be subject to any tax on gains created by the fund. This incentive circumvents quick wins for investors that might otherwise cash out profits and move on to other ventures outside of OZs.
The incentives behind QOFs were significant and private equity real estate firms were the first to mobilize, with many acquiring properties in areas that were already on the economic upswing. Retail investors and advisors took much longer to get acclimated, focusing more on the first two incentives of deferral and cost basis, when the real emphasis should be placed on tax free growth of wealth.
ROTH IRAs have been a sought-after retirement savings vehicle because of their ability to grow wealth tax deferred and ultimately have assets come out tax free. Investors have a limited ability to invest in ROTHs based on income thresholds and phase outs, but most seek ways to allocate as much as possible through individual accounts, ROTH-IRA Conversions, and back door strategies.
QOFs should be seen as a supplemental retirement account in the same fashion as a ROTH. Not only is the growth of wealth tax free, but much of the income is as well. Sponsors and developers are using cost segregation and depreciation to offset taxable income, with an added benefit that there is no recapture if sold for a gain.
Qualified Opportunity Fund Features
Timely financing events occur with many funds in 2026-2027 when developed properties stabilize and the original capital gains tax payments are due. Properties typically use construction financing or zero leverage at the outset, then ascertain 50-60% long term financing and send a portion as distributions to investors. These are characterized as a return of capital and not taxable.
QOFs are focused on many different development sectors: Multifamily, Student Housing, Self-Storage, Industrial, Life Sciences, Oil Drilling, etc.; and provide varying distribution and return targets to match investor needs. Portfolios range from single asset projects to billion-dollar portfolios with many sponsored by experienced real estate developers with strong demonstratable track records.
Tax Free Supplemental Savings
Each year, waves of retirees suddenly realize the dollar amount of their retirement accounts is a mirage and their assessable income is buried beneath a mountain of tax liability. Those that have the foresight to utilize ROTH IRAs and other tax advantaged strategies such as Qualified Opportunity Funds will most assuredly have greater spendable nest eggs in retirement.
Alternative Tax Management, LLC is an educational platform focused on tax mitigation strategies for accredited investors and their advisors. Holistic tax centric planning solutions are provided through a nationwide network of financial advisors, accounting, legal, real estate, and insurance professionals.