When Congress passed the Tax Cuts and Jobs Act (TCJA) of 2017, they included provisions creating Opportunity Zones. These zones allow eligible investors to defer and reduce their capital gains tax liability in return for investing in communities that could benefit from outside investments.
The goal of Opportunity Zones is to infuse much-needed capital in distressed parts of the United States. The goal of this article is to examine how Opportunity Zones work, including their tax benefits and potential risks.
Key Takeaways
- Opportunity Zones – geographical areas within the United States (and some of its territories) where investors can enjoy tax savings while also helping economically distressed communities.
- How to take advantage of these tax benefits – reinvest capital gains from a prior investment within 180 days of the sale of that investment.
- Eligibility – the reinvestment must be in a Qualified Opportunity Fund (QOF), which is an investment vehicle that invests in Opportunity Zones and meets special requirements.
- Tax benefits – the most notable include a deferral of capital gains tax, elimination of any tax liability on QOF investment gains, and no depreciation recapture of eligible Qualified Opportunity Zone Property.
- Risks – increased IRS scrutiny, the potential for negative returns, and extended investment horizons.
How Do Opportunity Zones Work?
The best way to explain how Opportunity Zones work is to first define their primary components:
- Opportunity Zone: Also known as a Qualified Opportunity Zone (QOZ), an Opportunity Zone is an economically distressed locality or community that has been chosen by the applicable state or territory and certified by the U.S. Secretary of the Treasury.
- Qualified Opportunity Fund: An investment vehicle used to help individuals and institutions invest in Opportunity Zones.
- Qualified Opportunity Zone Property (QOZP): The property that receives the outside investment from the QOF. This property can include stocks, partnership interests, or Qualified Opportunity Zone Business Property.
Conditions for Investments to Be Qualified Opportunity Funds
There are several conditions necessary for an investment to enjoy QOF status, but the three primary requirements are:
- The QOF must be structured as either a partnership or a corporation with the primary goal of investing in QOZP. A limited liability company is also an option, but it must be treated as a partnership or corporation for tax purposes.
- Each year, the QOF must file IRS Form 8996, Qualified Opportunity Fund, along with any other relevant tax returns.
- At least 90% of the QOF’s assets must be in QOZP.
Tax Benefits of Qualified Opportunity Zone Investments
Investors who face capital gains or 1231 tax liability (from selling certain business assets) may defer this tax liability by investing the funds from the capital gain or 1231 sale into a QOF. This deferment lasts until the QOF is sold or transferred or December 31, 2026, whichever is earlier.
If the investor holds the QOF investment for at least 10 years, any gains from the QOF investment will not be subject to tax. Or more precisely, when the QOF investment is sold, its basis gets stepped up to its fair market value. Finally, there’s no depreciation recapture when selling eligible depreciated QOZP.
Additional tax advantages used to exist, such as up to a 15% reduction in the capital gain amount subject to tax. However, as of December 31, 2021, those benefits have expired.
Opportunity Zone Tax Benefits Example
Let’s say your ordinary income tax rate is 35%. On January 1, you buy 1,000 shares of Acme Widget, Inc. for $100 per share. A few months later, you sell those 1,000 shares for $1,100 per share.
Your initial investment amount is $100,000, your final investment amount is $1,100,000, and your capital gain, subject to the short-term capital gain tax rate (which is your ordinary income tax rate of 35%), is $1,000,000. If you decide to keep the $1,100,000 and pay taxes on the capital gains, you’ll pay $350,000 in capital gain tax ($1,000,000 x 35%).
If you invest that $1,000,000 in a QOF within 180 days of the sale, you can defer the taxes owed until the earlier of December 31, 2026, or the date the QOF is sold or exchanged.
Now imagine you held onto this QOF investment for at least 10 years, and when you decided to sell it, it was worth $4,000,000. In addition to getting to delay when you paid the capital gains tax on the $1,000,000 capital gain, the $3,000,000 increase in value you received from your QOF investment would not be subject to tax. In other words, your QOF investment grows tax-free.
Opportunity Zone Investment Risks and Drawbacks
The biggest risk of investing in QOFs is the time needed to use the tax benefits fully. Other potential risks and disadvantages include:
- Limited transfer or sale options: Because QOFs aren’t typically sold or transferred on public exchanges, there may be increased transaction costs (in terms of time and money) when an investor is ready to sell.
- Increase scrutiny: Given the amount of money involved with Opportunity Zone investments, the IRS will focus more of its audit resources on Qualified Opportunity Fund investment tax returns and filings.
- Potential penalties: QOFs that fail the 90% asset test and other conditions could face penalties that might negate any tax benefits.
- Legal uncertainty: Congress may change the relevant tax laws, reducing tax benefits or making it more difficult to qualify for them.
- Riskier investments: By their very nature, QOFs are required to invest in economically struggling geographical areas. This could lead to lower investment returns than more conventional investing options, yet with higher risk.
How to Invest in an Opportunity Zone
Here are the steps for investing in an Opportunity Zone:
- Step 1: Sell property that results in capital gains or 1231 tax liability.
- Step 2: Invest the capital gains in a QOF within 180 days. This investment must be in an equity interest in the QOF.
- Step 3: Hold onto the QOF investment for 10+ years to maximize tax savings.
One thing to keep in mind is that while holding onto the QOF investment, you’ll need to complete additional paperwork with your taxes. For example, you’ll need to complete IRS Form 8949, Sales and Other Dispositions of Capital Assets, and IRS Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments. This first form is necessary to inform the IRS of the capital gains tax deferral you’re receiving.
Minimizing Opportunity Zone Investment Risks
The best thing to do is to consult with a financial advisor about the merits of these nontraditional investments. This advisor will ensure that this investment is right for you, that you’re investing in a legitimate QOF, and that the risk profile of the QOF meets your investment goals.
It also helps to diversify your money into other assets and stay apprised of any changes to IRS regulations or the Internal Revenue Code concerning Opportunity Zones.
Qualified Opportunity Zone FAQs
How can I tell if an investment qualifies for Opportunity Zone tax benefits?
The investment will be part of a Qualified Opportunity Fund (QOF), which is an investment vehicle that exists to invest in a Qualified Opportunity Zone (QOZ) property.
There are several special requirements that the investment vehicle must meet to be considered a QOF, and most QOFs aren’t available for sale to the general public. Instead, they’re typically sold to a select group of individuals and/or institutional investors. That being said, one way to confirm the legitimacy of a QOF investment is to ensure it has properly filed IRS Form 8996.
Can I sell my Opportunity Zone investment before 10 years?
Absolutely, but you’ll lose out on your QOF investment growing tax-free.
Can I put non-capital gains money into a Qualified Opportunity Fund?
Yes, but your options are limited. The only other non-capital gains money you can put into a QOF are qualified 1231 gains. Even then, these gains must not come from a transaction with a related person and must be recognized for federal income tax purposes by January 1, 2027.
What happens if the QOF doesn’t qualify as an Opportunity Zone investment?
The Qualified Opportunity Fund may be subject to monetary penalties and would likely lose its Opportunity Zone certification. Penalties can be avoided if “reasonable cause” can be shown in limited cases. A dispute over the Opportunity Zone Fund will affect both the fund and its individual investors.
How can I tell if a QOF is legitimate?
If you’re worried that a potential Opportunity Zone investment may be illegitimate, it’s best to consult with an appropriate financial advisor, as Qualified Opportunity Funds aren’t typically traded on public exchanges and therefore aren’t subject to the same level of regulatory scrutiny by the U.S. Securities and Exchange Commission.
This means most QOFs will only be available to accredited investors, who are usually either licensed investment professionals or high-wealth individuals. At a minimum, a legitimate QOF will be up-to-date with its IRS Form 8996 filings. And in these filings, there needs to be a legitimate census tract number for the OZ.
Opportunity Zone Tax Guidance
Opportunity Zones offer tremendous tax benefits, especially over extended investment horizons and when dealing with capital gains taxes. But they’re among the more complicated and risky investments. Before investing in a Qualified Opportunity Fund, it’s best to first consult with a tax professional, such as those from Wiggam Law. To schedule a consultation, call us at (404) 233-9800 or fill out our online consultation form.