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.
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.
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:
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.