Opportunity Zones were created under the Tax Cuts and Jobs Act to stimulate economic development and job creation by incentivizing long-term investments in low-income neighborhoods. States nominate blocks of low-income areas by census tract, which are then certified by the Secretary of the U.S. Treasury via his or her delegation of authority to the IRS. Through the IRS, investors can file Form 8996, Qualified Opportunity Fund, to create vehicles structured as either a partnership or corporation for the purpose of investing in an Opportunity Zone census track, whether in real estate or directly in businesses through equity. The fund is required to hold at least 90 percent of its assets in that qualifying Opportunity Zone area.
The Qualified Opportunity Fund must bring property new to the entity to be used in the Opportunity Zone. In addition, the Qualified Opportunity Fund must make substantial improvements to the property equal to the investment over a 30-month period (39 months if the substantial improvement period began prior to April 1, 2020 (Notice 2020-39). Businesses prohibited for Opportunity Zone investments include golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other facilities used for gambling, and liquor stores.
There are designated Qualified Opportunity Zones located in all 50 States, the District of Columbia, and five United States territories. Over the past three years, Qualified Opportunity funds have raised $75 billion, which has been a direct investment into the most underserved areas in our country.
An Opportunity Zone Fund investment provides potential tax savings in three ways:
#1: Tax Deferral through 2026. A taxpayer may defer the tax on a capital gain when investing in a Qualified Opportunity Fund if they comply with the investing timeframe restrictions. The taxpayer has 180 days to invest but Notice 2020-39 extended the investment deadline to Dec. 31, 2020 if the 180th day to invest would have fallen on or after April 1, 2020, and before Dec. 31, 2020.
#2: Step up in tax basis of deferred gains. The “5-year, 10% basis increase” is still available for taxpayers through Dec. 31, 2021.
Example: In July 2021, a taxpayer sells a zero-basis business for $5 million, which triggers a $5 million capital gain. The taxpayer invests the entire amount in a Qualified Opportunity Zone Fund within the timeframe restrictions, resulting in no tax on the sale proceeds in 2021. On Nov. 1, 2026, the taxpayer receives a 10% adjustment to their cost basis in the Qualified Opportunity Zone investment amounting to $500,000. On Dec. 31, 2026, the taxpayer must recognize the deferred gain on the sale of the investment, and their cost basis for determining the total gain is $500,000. Assuming the overall value of the Quality Opportunity Zone investment has not decreased, then the taxpayer will pay the capital gain on $4.5 million ($5 million 2021 gain, reduced by the 5-year 10% basis adjustment of $500,000) and the taxpayer must reflect that gain on their 2026 federal income tax return to be filed in 2027.
#3: No tax on appreciation. If a taxpayer stays in the Qualified Opportunity Fund for at least 10 years the cost basis of the property will equal the fair market value on the date of sale/exchange.
Example: In 2021, a taxpayer makes a $5 million investment in a Qualified Opportunity Zone Fund. In 2035, the taxpayer sells the investment for $10 million. The $5 million in appreciation is not taxable. At current federal capital gains rates, that is a tax saving of over $1 million. The taxpayer will, however, have phantom income (taxable income without corresponding sale) on the original $5 million investment in 2027 for the 2026 tax year, since the investment in the fund was held beyond Dec. 31, 2026, when the deferred gain on the original investment must be recognized.
The capital gains tax rate in 2026 is unclear. It is possible President-elect Biden will raise the rates to 39.6%, plus the 3.8% Obamacare tax. The year 2026 occurs after the 2024 presidential election, which may result in another change in administration and possible tax rate changes. It is clear, however, that billions of dollars of deferred capital gains may be recognized in 2026.