Opportunity Zone Tax Benefits

WHAT IS THE OPPORTUNITY ZONE TAX INCENTIVE?

The Opportunity Zone (OZ) tax incentive is an economic development tool established by the Tax Cuts and Jobs Act to incentivize investment into distressed communities throughout the United States. It provides lucrative tax incentives to investors to make qualified investments of capital gains in Opportunity Zones through Qualified Opportunity Funds (QOFs), which are essentially “pass-through” entities specifically created for this purpose. The aim is to promote economic development and job growth in low-income and economically troubled areas. Here’s a rundown of the key tax benefits and how they work.

What are Opportunity Zones?

Opportunity Zones are economically distressed communities that have been nominated by governors of states and certified by the U.S. Secretary of the Treasury. These areas were defined with the purpose of creating private investment that would rehabilitate and restore neighborhoods. In total, there are 8,764 Opportunity Zones in the U.S., including all 50 states, the District of Columbia, and U.S. territories. All of Puerto Rico’s low-income communities were also designated as Opportunity Zones, effective December 22, 2017.

What is a Qualified Opportunity Fund (QOF)?

A Qualified Opportunity Fund (QOF) is an investment vehicle that was specifically designed to invest in either businesses or properties located in an Opportunity Zone. In order to qualify, a QOF must hold at least 90% of its assets in Opportunity Zone property. If an investor reinvests capital gains into a QOF, they can be entitled to a number of tax benefits.

Opportunity Zone Investment Tax Benefits

There are several tax incentives available to investors in Opportunity Funds to encourage investment in Opportunity Zones. These incentives are very attractive:

1. Deferral of Capital Gains

If eligible, investors can defer tax on realized gains (capital gains and qualified 1231 gains) caused by the sale of a QOF property. The tax deferral continues until the earliest of:

• The date such QOF investment is sold or exchanged, or
• December 31, 2026.

This means that the tax on the capital gain is deferred, which effectively means an interest-free loan from the federal government until such a date or event.

2. Basis Step-Up

The normal timeline for a QOF is determined by the length of time an investor holds their QOF investment. Specifically:

• Holding Period – 5 Years: Investors are entitled to a 10% increase in their basis in the deferred gain.
• Holding Period Over 7 Years: There is the option to receive a 15% basis increase on the deferred gain.
• Holding Period Over 10 Years: After 10 years, investors can adjust the basis of their QOF investment to its fair market value at the time of sale, which eliminates any capital gains tax on the appreciation in the investment.

This makes a 10-year holding period particularly advantageous for maximizing tax-free growth on the investment.

3. Tax-Free Growth After 10 Years

Perhaps the most significant benefit of Opportunity Zone investing is the elimination of taxes on gains that accrue in the QOF over a 10-year holding period. After 10 years, investors can sell their QOF investments and pay no capital gains tax on the profits, provided the investment was held for the required period.

Eligible Gains and Reinvestment Requirements

To qualify for these tax benefits, eligible gains must be reinvested into a QOF. Eligible gains include:

• Capital Gains: Profits from the sale of assets such as stocks, bonds, or real estate.
• Qualified 1231 Gains: Gains from the sale of business property, such as real estate.

The gain must be reinvested within 180 days of the sale or exchange that triggers the gain. Once the gain is reinvested in a QOF, investors can defer the tax liability until 2026 or until the QOF investment is sold or exchanged.

Qualified Opportunity Funds and Reporting Requirements

A Qualified Opportunity Fund (QOF) must be a corporation or partnership that invests at least 90% of its assets in Opportunity Zone properties. To maintain QOF status, the fund must file Form 8996 annually with the IRS. Additionally, investors who hold a QOF investment must file Form 8997 annually to report the deferral of capital gains and ensure compliance with Opportunity Zone regulations.

Failure to file the required forms can result in penalties, including the presumption of an inclusion event, which would terminate the investor’s deferral of gains.

Qualified Opportunity Zone Property and Business

To qualify as an Opportunity Zone investment, the property or business must meet specific criteria:

• Qualified Opportunity Zone Property: This includes tangible property used in a QOF business located within a Qualified Opportunity Zone or a qualified interest in a corporation or partnership operating within a Qualified Opportunity Zone.
• Qualified Opportunity Zone Business: A business must meet certain requirements to be classified as a QOZ business, including earning at least 50% of its gross income from business activities within a QOZ.

Leased properties can also qualify if they meet specific requirements, such as being leased under market rate conditions and used for business in the QOZ.

Investor Reporting and Compliance

Investors must be proactive in reporting their QOF investments to remain in compliance with Opportunity Zone regulations:

• Form 8997 must be filed annually to report deferred gains and track compliance with Opportunity Zone regulations.
• Form 8949 is used for reporting capital gains and sales of investments.

It’s crucial that investors meet these reporting requirements to avoid penalties or losing out on the tax benefits.

Conclusion

The Opportunity Zone tax incentive offers substantial tax benefits for investors who are willing to make long-term investments in economically distressed communities. These benefits include the deferral of capital gains, reduction in tax liability for investments held for five and seven years, and the potential for tax-free growth after holding the investment for 10 years. By investing in Qualified Opportunity Funds, investors can help revitalize struggling communities while benefiting from substantial tax savings.

For additional details on Opportunity Zone tax incentives and to access official forms, please refer to the IRS Opportunity Zones page.