In order to expand investment in lower income areas, the federal government created Opportunity Zones as part of the Tax Cuts and Jobs Act of 2017 (TCJA). Capital gain tax incentives were created within these zones to incentivize private investment in these historically distressed communities. These areas were created through a nomination and designation process, and in June of 2018 the US Department of Treasury Certified 8,761 communities. Then in October, the IRS issued proposed regulations covering the implementation of Opportunity Zone Tax Incentives.
The Benefit of Investing in Opportunity Zones:
The primary benefit is the deferral of capital gains. If a taxpayer invests realized capital gains into a Qualified Opportunity Fund (QOF), they can defer paying capital gains until April 2027 if they hold the assets through December 31, 2026. Additionally, taxpayers that have held their Opportunity Fund Investments for at least five years prior to December 31, 2026 will see a reduction in their gain by 10 percent. If the investment has been held for seven years as of December 31, 2026, the gain reduction is increased by 5 percent to a total of 15 percent.
The tax incentive gets better if the property appreciates over time. For taxpayers that hold the property for at least 10 years, no capital gains will be owed on the appreciation of the Opportunity Zone investment. This is done by increasing the basis of the property to Fair Market Value.
For example, if a taxpayer invests $1 million in realized capital gains in a QOF in 2018, the capital gains are deferred. In 2023 after five years, the tax on the original gain is reduced by 10 percent. Then in 2025 the tax on the original gain is reduced by another 5 percent. On December 31, 2026, the original gain is realized, minus the 15 percent reduction. Then if the taxpayer still owns the property in 2028, 10 years from the original investment, any additional capital gains are eliminated. If the taxpayer then sells the investment for $2 million no additional capital gains taxes are due.
How Opportunity Zone Investment Works:
In order for a taxpayer to realize the benefits of investing in an Opportunity Zone, the taxpayer must invest their gains into a QOF within 180 days of the event triggering the capital gain. In most cases this 180 days begins with the date of the sale or exchange giving rise to the gain.
The investment must be made through an investment vehicle known as a QOF. A QOF is a partnership or corporation that holds at least 90 percent of its assets in Qualified Opportunity Zone property. In order to become a QOF, an eligible partnership or corporation, self certifies by filing a Form 8996 with their tax return.
Investing in Real Estate:
The qualifications require the property be new, or “substantially improved” property. This means either a QOF must invest in either new property, or must substantially renovate the property. In order to meet the substantial rehabilitation test, the QOF must add additions to the property, equal to the basis, over a 30-month period. This means a QOF that invests in a $1 million building in an Opportunity Zone, must put another $1 million into the property over a 30-month period to meet the requirements.
Pitfalls of the Opportunity Zones:
Right now there is a rush to invest in real estate located within Opportunity Zones. However, it is important for taxpayers to remember the real benefit comes from the forgiveness of gain on appreciation after 10 years. This means a poor investment that sees little to no appreciation after 10 years is not a good investment opportunity. As with many new tax incentives, the benefits can be significant for the correct investment. However, it is critical that investments are reviewed carefully.
While McGuire Sponsel is doing some hourly consulting on this new area of tax law, we do not currently have a practice specializing in Opportunity Zones. However, there are often intersections between Opportunity Zones, Cost Segregation, and other incentives. If there are any questions regarding these incentives or how they affect cost segregation, or State and Local Incentives, please let us know.