Opportunity zones (OZs) provide an opportunity to invest capital gains in real estate while deferring tax payment on those gains. It’s important to know which capital gains are eligible. Otherwise, you might invalidate your OZ (opportunity zone) tax benefits. In this article, we’ll dig into the details of what makes an eligible opportunity zone capital gain.
IRS Governing Codes
IRS Governing Codes are specific sections of the IRS code database. IRC section 1400Z-1 governs opportunity zones, and section 1400Z-2 governs opportunity funds. It is section 1400Z-2 that we are interested in. This section defines eligible capital gains.
The Department of Treasury REG-115420-18 does a good job of outlining 1400Z-2. Page 6, section A states, in reference to IRC section 1400Z-2(a)(1), “gain from the sale to, or exchange with, an unrelated person of any property held by the taxpayer,” to the extent that such gain does not exceed the aggregate amount invested by the taxpayer in a QOF (qualified opportunity fund) during the 180-day period beginning on the date of the sale or exchange (emphasis added).
Both ordinary and capital gains are eligible. From REG-115420-18, “eligible gains, therefore, generally include capital gain from an actual, or deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.”
When you sell an asset, a 1031 exchange requires a like-kind property. QOZs don’t have this requirement, which means you can reinvest capital gains earned from the sale of stocks, bonds, art, real estate, etc.
As for whether a gain is a capital gain, your tax advisor should be able to make the final determination.
The Many Faces Of Capital Gains
Capital gains cover a broad universe of gains, so let's look at a few common capital gains that are acquired by real estate investors.
Short-Term and Long-Term
Short-term gains are those on an asset held for one year or less. Short-term gains are taxed at your ordinary income tax rate. Long-term gains occur on assets held for more than a year. They are taxed 0 percent, 15 percent, and 20 percent, depending on your income level.
Section 1231 assets (property or buildings) are those used in a trade or business and held for more than one year. Gains from the sale of a section 1231 involve depreciation recapture, which has its own special 25% capital gains rate. To understand how this works, let’s look at an example. Say you have a cost basis of $200,000 in a building that you’ve held for five years. There is $50,000 of depreciation. The building can be sold for $280,000. Breaking that down, we have:
Cost Basis $200,000
Depreciation - $50,000
Adjust Basis = $150,000
Sales Price $280,000
Adjusted Basis - $150,000
Gain = $130,000
Hypothetical example, for illustrative purposes only.
Of the $130,000 gain, $50,000 is depreciation recapture and taxed at a rate of 25%. The remaining $80,000 is taxed at your long-term capital gains rate.
The final OZ regulation changes allow investors to immediately use Section 1231 gains during the year as contributions to a QOF (qualified opportunity fund), despite any 1231 losses they may have during the year that reduce their total 1231 gain.
RICs or REITs
Coming directly from the Federal Register, released on 1/31/2020, as it applies to holders of shares in a Regulated Investment Company (RIC) or Real Estate Investment Trust (REIT), “The 180-day period with respect to the included undistributed capital gain begins, at the shareholder's election, on either the last day of the RIC or REIT's taxable year or the last day of the shareholder's taxable year in which the amount would otherwise be recognized as long-term capital gains by the shareholder.”
Basically, the above is saying that the shareholder can elect their 180-day period to begin based on the entity’s last taxable day or their personal/individual last taxable day. Remember that the 180-day period is the time frame from the date of the sale that generates gains to the investment of those gains into a qualified opportunity zone fund. This is similar to the 180-day period that you find in a 1031 exchange.
December 31, 2026 Deadline And Related Parties
Any gain that you’re going to invest in an OZ must be recognized for federal income tax purposes by December 31, 2026. Another key component of an eligible gain is that it cannot arise from the sale or exchange with a related party. A related party is someone who you have a 20% direct or indirect relationship either before or after the sale.
Opportunity zones have lots of regulations and rules to follow. Navigating that landscape is essential to ensuring your capital gains are eligible for OZ tax benefits. Working with your tax or financial advisor can help take some of the complexity out of investing your capital gains into OZs and make sure that everything goes smoothly.
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.
There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities.
Realized does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
What is a Qualified Opportunity Zone?
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