What Happens to Depreciation Recapture in an Opportunity Zone?

Posted Mar 23, 2023


There’s been a great deal of discussion about the Opportunity Zone Program since its introduction as part of the Tax Cuts and Jobs Act of 2017. The program’s focus is on investors with capital gains resulting from the sale of capital assets. Specifically, investors funnel those gains into Qualified Opportunity Funds. The QOFs, in turn, use that money to benefit federally designated, generally low-income Qualified Opportunity Zones.

In return for putting capital gains into QOFs, investors receive a plethora of tax benefits. Some of them have been highly publicized, like a step-up in the tax basis of up to 15% of deferred gains (which expired in late 2021). Another much-discussed benefit involves capital gain tax deferral and potential elimination.

But a benefit that hasn’t been in the limelight is what happens to depreciation recapture connected with QOF investments. The simple answer is that depreciation recapture goes away, as long as the investor keeps their QOF holdings for 10 years or longer.

A Depreciation Recapture Refresher

Let’s review the concept of depreciation recapture. Physical assets, like real estate, wear down over time. The IRS understands this loss in functionality and responds by letting investors take the property’s value as deductions against income. This means that whatever is paid to buy a property (excluding the cost of land) can be depreciated on a straight-line basis over 27.5 years (for residential property) or 39 years (for commercial property).

But when the investor sells their property, the IRS wants part of those deductions back. This is depreciation recapture, which is equal to 25% of the aggregate depreciation allowance taken during the investment’s holding period.

The good news is that allowable depreciation on a real estate asset can be used against taxable income. The bad news is that once the investor sells the asset, they’re taxed 25% of the total depreciation allowance that was taken.

Potential Long-Term Hold Benefits

In most cases, an investor can only defer a depreciation capture—and taxes on capital gains—by conducting a 1031 exchange. But those who invest in QOFs, and hold those investments for a decade or longer, benefit in two ways:

  • Elimination of taxes on capital gains earned within the QOF 
  • Elimination of depreciation recapture upon the QOF’s sale

As such, QOF investors who take the long view toward their investments in Qualified Opportunity Zones could benefit from long-term tax savings.

But using the Opportunity Zone program as a depreciation recapture avoidance strategy is very complex, involving deadlines, guidelines, and careful planning. As such, it’s essential to work with a qualified professional that is well-versed in the Opportunity Zones program legislation and regulations.

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.

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.

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.

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