An opportunity zone is a real estate investment with potential special tax advantages. Depreciation is one of the biggest tax benefits for any real estate investor. Since an opportunity zone already has tax benefits, how does it treat depreciation?
When an investor buys an opportunity zone (OZ), they can take an annual depreciation expense just like other investment properties. However, there is some special tax treatment because of the qualified opportunity zone (QOZ) designation.
Investors can deduct up to $1 million in depreciation per year for their QOZ investments until 2023. The deduction can go against (passive) income received from the investment.
The IRS allows investment property owners to take an annual depreciation expense. This expense can accumulate to a significant amount over several years. However, once the property is sold, the IRS will want a portion of this depreciation back.
This recapture of depreciation is called, you guessed it, depreciation recapture. It is taxed at a maximum of 25%. This is the most expensive real estate investment tax outside of a short-term sale. Unlike long-term capital gains, there is no tax break on depreciation recapture.
For example, if the unrecaptured gain on the sale of a property was $125,000, at 25%, the depreciation recapture tax would be $30,625.
While depreciation recapture may not offer any tax breaks, investors who have held an OZ investment for at least 10 years are in luck. That’s because depreciation recapture is eliminated on these investments. This is not to be confused with a tax deferral, where the tax must eventually be paid. Once the investor exits their OZ investment at the 10-year mark, they will not owe depreciation recapture taxes.
You might notice that this 10-year holding period coincides with the elimination of taxes on capital gains of the OZ investment under certain conditions.
QOZs have many rules and specific timelines that must be followed in order to meet their tax benefits. It’s important that all of these rules be adhered to when considering investing in a QOZ. Working with a tax specialist can help ensure that these complex rules are followed correctly.