The Opportunity Zones program offers the potential of deferred capital gains, slightly reduced cost basis for capital gains, and tax-free appreciation for investors in designated economically distressed communities. Created in the Tax Cuts and Jobs Act, the program essentially allows the creation of funds to seed new businesses, invest capital to expand existing businesses, or develop real estate.
While Qualified Opportunity Zones can offer some interesting tax plays, they’re complicated. The Internal Revenue Service only recently proposed regulations for these tax-preferred investments, and quite a bit of guidance remains to be issued. Here are a few key frequently asked questions to keep in mind.
What is a Qualified Opportunity Zone?
A Qualified Opportunity Zone is a population census tract that has been designated as economically distressed. There are 427 Opportunity Zones in Florida, recommended to be designated by Gov. Rick Scott and certified by the U.S. Department of Treasury. Miami-Dade County alone has 67 Opportunity Zones. The zones are based on census data from nine years ago, though, and a lot can change in that many years- particularly in South Florida. Some Opportunity Zones are clearly economically distressed, others are in up-and-coming areas, and still others are in areas that don’t really seem to need the investment incentive at all. The website Opportunity 360 lets you search for Qualified Opportunity Zones.
What are the benefits of an Opportunity Zone investment?
A correctly structured Qualified Opportunity Fund can provide investors with three main benefits:
- The ability to defer tax on any prior capital gains invested in the Qualified Opportunity Fund until the date the fund is sold or exchanged, or December 31, 2026 – whichever comes first. From the time you sell an investment that incurs capital gains, you have 180 days to invest it into a Qualified Opportunity Fund in order to defer those gains. Should the capital gain be earned inside of a pass through entity then you may have the ability to elect to start the 180-day clock as of the last day of the entity’s year end.
- After five years, your initial capital gains basis is stepped up by 10%. After seven years, your initial capital gains basis gets a 15% bump resulting in permanent deferral of 15% of your original capital gain.
- If you hold the investment for 10 years or longer, it will appreciate tax-free
IRS regulations define capital gain as anything that’s treated on a tax return as capital gain – including long-term, short-term, 1231 gain and, possibly, unrecaptured 1250 gain. The IRS is still issuing related guidance.
How do I invest in a Qualified Opportunity Zone?
Companies or individuals must invest in Opportunity Zones through a Qualified Opportunity Fund which can be set up as either a partnership or a corporation. This includes LLCs that choose to be treated as either partnerships or corporations for federal tax purposes. The fund must then invest in real estate or a company in an Opportunity Zone. In a Qualified Opportunity Fund, 90% of its assets must qualify for the Opportunity Zone benefit. However, a fund may instead invest in a partnership that is a Qualified Opportunity Zone business – in such a business, only 70% of the assets have to qualify, and there is an exemption for working capital.
What are some examples of Qualified Opportunity Zone investments?
A Qualified Opportunity Fund may purchase or invest in an existing business in an Opportunity Zone. It may acquire, develop or invest in land or buildings in an Opportunity Zone. However, a fund cannot simply buy an existing property in an Opportunity Zone – it must make a substantial improvement of a qualified property, which is defined as spending more than 100% of the value of the building, within 30 months of acquiring it.
How can businesses in Opportunity Zones benefit?
An owner looking to sell real estate in a zone may find that the tax incentives can make potential buyers’ economics easier to work out, and may lead to more offers for the property. For a company located in an Opportunity Zone, the tax-preferred treatment of properly structured investments in those businesses may offer an extra incentive for much-needed outside cash. Another benefit to keep in mind is that if a company located elsewhere needs, for instance, industrial space, it may consider building in an Opportunity Zone through a properly structured fund.
Which types of investors might an Opportunity Fund work best for?
The tax benefits accrue over the long term, and the idea behind Opportunity Zones is to spur economic activity in places that are currently distressed (even if all Opportunity Zones aren’t actually currently distressed). So, long-term investors with stable cash flow are good candidates for these types of investments.
What should an individual or company consider before deciding to invest in a Qualified Opportunity Fund?
Most importantly, as with any investment, the underlying fundamentals of the investment must make sense for you, not just from a tax perspective. Ask some important questions: Will it make sense to hold this asset for the five, seven, or 10-plus years the regulations require? What is the downside risk if this neighborhood doesn’t actually increase in value? Finally, be clear and seek help with the structure of the investment and any projects, as the interplay between the economics and statute can quickly become complicated.
What are some regulatory uncertainties to be aware of?
A big question is what will happen in 2026 when the initial capital gains invested in many Opportunity Funds come due to the IRS? Will there be a massive sell-off of assets as people scramble for cash? Other uncertainties include what happens when a Qualified Opportunity Fund that owns multiple assets sells one or two of its assets. Also, the IRS hasn’t yet issued guidance on what happens when an investor wants to exit an Opportunity Fund. The next set of guidance is expected to be released soon, so hopefully more answers will be available in the coming months.
To learn more about Opportunity Zones and how your business may be able to benefit, read the IRS FAQ, and contact your Kaufman Rossin tax professional.