Opportunity Zones have been a buzzword in the real estate investment community since their creation in 2017. They offer significant tax advantages for investors looking to defer or reduce capital gains taxes while stimulating economic development in underinvested areas. In this blog, we'll explore the details of how opportunity zones work, discuss key dates, evaluate the pros and cons of direct property investment versus investing in a fund, and analyze whether this program might be extended. We'll also look at why builder/operators might be a strong option and provide an example of how the tax benefits work in practice.
What Are Opportunity Zones?
Opportunity Zones are designated geographic areas that have been identified as economically distressed. These zones were created as part of the Tax Cuts and Jobs Act of 2017, under the leadership of U.S. Senator Tim Scott and with bipartisan support. The goal is to incentivize investment in low-income communities by offering tax breaks to those who reinvest capital gains into these areas.
There are over 8,700 designated Opportunity Zones in the United States, spanning urban, suburban, and rural regions. Investments must be made through Qualified Opportunity Funds (QOFs), which pool capital to invest in real estate or business developments in these zones.
Key Dates and Deadlines
- December 22, 2017: The Opportunity Zone program was established under the Tax Cuts and Jobs Act.
- December 31, 2026: This is a critical date. It's the deadline to invest in an Opportunity Zone and still qualify for the deferral of capital gains. Investors can defer paying taxes on those gains until this date or when they sell their Opportunity Zone investment, whichever is earlier.
- 2027 and beyond: While the ability to defer capital gains ends in 2026, the benefits of holding investments within Opportunity Zones last longer. Specifically, investors can continue to realize the full tax-free benefit on appreciation in the property or fund if they hold the investment for at least 10 years.
How Do Opportunity Zones Work?
The core idea of Opportunity Zones is to offer tax incentives to investors in exchange for driving capital into underserved areas. Here's a breakdown of how it works:
- Deferral of Capital Gains: When you sell an appreciated asset (like stocks or real estate), you can defer the capital gains tax by reinvesting those gains into a Qualified Opportunity Fund within 180 days. The deferral lasts until the earlier of when you sell the QOF investment or December 31, 2026.
- Reduction of Capital Gains: If you hold your QOF investment for at least five years, 10% of the original capital gains will be excluded from taxation. If you hold it for at least seven years, 15% of the gains will be excluded.
- Exclusion of Future Gains: The most attractive benefit of Opportunity Zones is that if you hold your investment for 10 years or more, any additional gains from the Opportunity Zone investment are tax-free.
Should You Buy a Property or Invest in a Fund?
When investing in Opportunity Zones, you generally have two choices: buy property directly within the zone or invest in a Qualified Opportunity Fund (QOF) that pools investors' money for larger projects.
Buying Property
- Pros: You have full control over the property, including development and management decisions. You can also tailor your investment to your specific goals, such as short-term rental income or long-term appreciation.
- Cons: Direct property investment requires significant due diligence and operational expertise. You’ll need to meet the substantial improvement requirement, which mandates that you invest an amount equal to the property’s purchase price into improvements over a 30-month period. This can be a significant burden for individual investors.
Investing in a Fund
- Pros: QOFs allow you to invest in larger-scale projects that you may not have the resources to handle individually. These funds are managed by professionals, which removes the day-to-day responsibilities of property development and management.
- Cons: You don’t have control over specific property decisions. Additionally, fund fees and performance vary widely, so it’s essential to conduct due diligence when choosing a fund.
Tax Advantages of Opportunity Zones
The tax incentives for investing in Opportunity Zones are highly attractive:
- Capital Gains Deferral: Investors can defer taxes on capital gains by reinvesting them into a QOF.
- Step-Up in Basis: If the investment is held for five years, investors receive a 10% step-up in basis, meaning they will only pay taxes on 90% of the original capital gains. After seven years, the step-up increases to 15%.
- Tax-Free Gains After 10 Years: The real kicker is that any appreciation in the value of the Opportunity Zone investment after 10 years is completely tax-free. This makes long-term investment especially attractive for those looking to maximize returns.
Could the Opportunity Zone Program Be Extended?
As of now, the Opportunity Zone program has a clear sunset period, with 2026 being the last year to qualify for the deferral benefits. However, there has been discussion about extending the program due to its potential to drive economic growth in distressed areas.
While nothing has been formally proposed, an extension could be a possibility depending on future legislative priorities. Investors should stay informed about any potential changes, as this could impact the long-term benefits of investing in these zones.
Accounting Example of Opportunity Zone Benefits
Let’s look at a simple example to illustrate the tax advantages of an Opportunity Zone investment:
- You sell a stock in 2023 and realize a capital gain of $500,000.
- You invest the full $500,000 into a QOF within 180 days.
- You hold the investment for 10 years, during which time the value of your Opportunity Zone investment grows to $1,000,000.
Tax Benefits:
- You defer paying taxes on the original $500,000 gain until December 31, 2026.
- After holding for 10 years, you receive a complete exclusion of tax on the additional $500,000 gain in the Opportunity Zone, meaning you pay no taxes on the appreciation.
Builder/Operators as Funds: A Strong Option
Builder/operators are companies that both develop and manage the projects they invest in. As Qualified Opportunity Funds, builder/operators can be a particularly attractive investment because they control every aspect of the development process—from acquisition and construction to management and operation.
This structure allows for greater alignment of interests between the fund manager and the investor. Builder/operator funds also tend to be vertically integrated, meaning they have the resources to meet the substantial improvement requirements more efficiently.
Can You Still Invest in Opportunity Zones?
Yes, there’s still time to invest in Opportunity Zones, but the clock is ticking. You can defer capital gains taxes by investing in a Qualified Opportunity Fund until December 31, 2026. To maximize the benefits, including the 15% reduction in capital gains, investments should be made by the end of 2023.
Why Opportunity Zones Still Matter
Opportunity Zones remain one of the most attractive real estate tax incentives available today. They not only offer significant tax breaks but also allow investors to make an impact by revitalizing distressed communities. With careful planning, Opportunity Zones provide a unique opportunity to combine financial returns with social benefits.
