What Are Opportunity Zones, And How Can They Work For Investors?

One of the most discussed changes brought about by the Tax Cuts and Jobs Act of 2017 was the creation of Opportunity Zones under Section 1400Z of the Internal Revenue Code. But what are they, and how do they work? Joshua Moore explains.

What are Opportunity Zones?

Opportunity Zones were created to spur investments into designated census tracts that have been identified as low-income areas.  By investing in Opportunity Zones, investors are able to defer and potentially reduce existing capital gains as well as potentially eliminate future capital gains.

The legislation allows taxpayers to defer capital gains if the gains are reinvested into a Qualified Opportunity Zone Fund within 180 days of its sale date.  As opposed to a like-kind exchange under Section 1031 of the Internal Revenue Code, which requires all proceeds from the sale to be reinvested to defer capital gains, only the amount of capital gain is required to be invested into a Qualified Opportunity Zone Fund.  

View a list of Qualified Opportunity Zones by clicking this link.

A Qualified Opportunity Zone Fund is any corporation or partnership that has been established for the purpose of investing in Qualified Opportunity Zone Property.  Taxpayers are able to self-certify with the IRS that they are a Qualified Opportunity Zone Fund by attaching a form to their timely filed income tax return.

How do Opportunity Zones work?

The capital gain reinvested into a Qualified Opportunity Zone Fund is deferred to the recognition date —  this date is whichever comes first: the date of disposition of the Qualified Opportunity Zone Property or December 31, 2026.  

If the Qualified Opportunity Zone Property is held for at least 5 years, the taxpayer receives a 10% step-up in basis and only recognizes 90% of the deferred gain on recognition date.  If the Qualified Opportunity Zone Property is held for at least 7 years, the taxpayer receives an additional 5% step-up for a total step-up of 15% and only recognizes 85% of the deferred gain on recognition date.  If the Qualified Opportunity Zone Property is held for at least 10 years, the taxpayer receives the same 15% step-up and only recognizes 85% of the deferred gain on the recognition date.

The taxpayer can also elect to step-up the basis of the investment to the fair market value on the date of sale and not have any gain after the recognition date. In this instance only 85% of the deferred gain will be recognized on December 31, 2016, any future gain will not be taxable.

An Opportunity Zone example

Here’s a good example of an Opportunity Zone at work:

If an investor sells property with a tax basis of $1,000,000 and a fair market value of $1,500,000 they will have capital gains of $500,000.  They can defer this gain by investing $500,000 into a Qualified Opportunity Zone Fund.

  • If the Qualified Opportunity Zone Property is held for less than 5 years then the $500,000 gain will be recognized on the recognition date (defined previously).  Any appreciation on the Qualified Opportunity Zone Property will be recognized when they dispose of the Qualified Opportunity Zone Property.

  • If the Qualified Opportunity Zone Property is held for between 5 and 7 years then the taxpayer will receive a step-up for 10% of the deferred gain ($50,000 or 10% of $500,000) and recognize $450,000 of gain on the recognition date. Any appreciation on the Qualified Opportunity Zone Property will be recognized when they dispose of the Qualified Opportunity Zone Property.

  • If the Qualified Opportunity Zone Property is held for between 7 and 10 years then the taxpayer will receive a step-up for 15% of the deferred gain ($75,000 or 15% of $500,000) and recognize $425,000 of gain on the recognition date.  Any appreciation on the Qualified Opportunity Zone Property will be recognized when they dispose of the Qualified Opportunity Zone Property.

  • If the Qualified Opportunity Zone Property is held for more than 10 years then the taxpayer will receive a step-up for 15% of the deferred gain ($75,000 or 15% of $500,000) and recognize $425,000 of gain on the recognition date, which will be December 31, 2026, in this case.  The taxpayer can then decide if they want to step up the basis of the property to its fair market value on the date of disposition so that any appreciation on the Qualified Opportunity Zone Property will not be recognized when they dispose of the Qualified Opportunity Zone Property.  In this case, only 85% of the taxpayers initial deferred gain will be recognized and any future gain will be excluded.

Based on the 5 and 7-year holding requirements, the latest an investor can invest in a Qualified Opportunity Zone Fund to receive the 10% step-up is 2021, and the latest an investor can invest in a Qualified Opportunity Zone Fund to receive the 5% step-up is 2019.

Opportunity Zone takeaway

It is important for developers and investors to be aware of the benefits offered by the Opportunity Zone program so that they can take advantage of it while planning new projects and evaluating investments.  

If you have any questions about the benefits offered by this program, please contact us so that we can help you take full advantage of this program and avoid any potential pitfalls.

Joshua Moore, CPA, is a senior tax manager at Market Street Partners. You can reach him at [email protected].