Qualified Opportunity Zones came to be as part of the 2017 Tax Cuts and Jobs Act (TCJA). Some key elements of the TCJA are:
- Reduced tax rates for businesses and individual taxpayers.
- Raised the standard deductions.
- Reduced the ease and value of itemizing deductions.
- Limited the deductibility of state and local income taxes.
- Limited the mortgage interest deduction.
- Reduced the alternative minimum tax for individuals and repealed it for corporations.
- Repealed the individual mandate for the Affordable Care Act (ACA).
- Created IRC Subchapter Z, relating to Opportunity Zones.
The primary goal of the Opportunity Zone program is to promote investments in economically challenged areas through reinvestment of capital gains. The program offered two tiers of tax reduction, but the time for receiving the first benefit has expired. That portion of the program related to an available increase in basis for new gains from other assets that were reinvested into a QOZ. To reap the benefits of that provision, investors needed to act before the end of 2021.
Furthermore, capital gains taxes on investments made using capital gains from other sources into QOZ funds are deferred only until 2026. At that time, the taxes are due. Therefore, investors could obtain a potential reduction of ten or fifteen percent if the investment was made before the applicable deadline and held for the time required.
QOZ investments can still appreciate without incurring capital gains tax liability
Investments made using capital gains from other sources (including the sale of real estate, stocks, or bonds) will not owe capital gains taxes on the appreciation within the QOZ Fund if the investment is held for at least ten years. For example, suppose an investor reaps a gain of $100,000 from selling real estate and invests the $100,000 into an approved QOZ project. The investor maintains the holding for at least ten years, during which the $100,000 grows to $200,000. The investor will not owe capital gains taxes on that gain. Keep in mind that the investor will owe capital gains taxes on the original amount in 2026 but not on the profit accrued in the QOZ.
QOZ rules are complex
For an investment to be eligible for the deferral and elimination of capital gains taxes, it must adhere to IRS rules. The stipulations include the location, which must be inside one of the more than 8,700 designated Opportunity Zones. Each state and territory had the opportunity to nominate census tracts for inclusion in the program, with the final list curated by the Treasury Department.
In addition, the project must satisfy the other requirements, including:
- Ninety percent of the assets held by a QOZ Fund must be within the Opportunity Zone.
- The project must substantially improve an existing property within 30 months of acquisition, with some exceptions for vacant property. Original-use acquisitions don't need to meet this improvement requirement.
- The QOZ business must earn at least 50 percent of its gross income from business activities inside the QOZ.
QOZ projects were slow off the starting line
The TCJA was passed in December 2017. However, it took the Treasury and the IRS almost two more years to finalize the applicable regulations. This delay ended as the Covid-19 pandemic sent uncertainty through most economic sectors, further slowing the initiation of many projects. According to Forbes, some advisors remain cautious of the investments, which should only be considered long-term and are riskier than alternatives.1
However, the IRS expects the amount invested to reach $100 billion, with over $75 billion already in place by the end of 2021. However, some financial advisors recommend that potential investors consider the tax benefits a bonus, not a reason to join a program that doesn’t make sense otherwise.
1 Forbes, “What Investors Need to Know About Investing in Opportunity Zones,” Ehud Gersten, June 23, 2022, https://www.forbes.com/sites/forbesfinancecouncil/2022/06/23/what-investors-need-to-know-about-investing-in-opportunity-zones/?clickid=baf07c36-a8ab-11ed-bb8a-0afb117bfcd5&sh=347b1cb051d0
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
