What Are They? How do They Work? Why do They Work?
Thanks to some recently-enacted tax legislation resulting from the 2017 Tax Cuts and Jobs Act (TCJA) taxpayers can defer capital gains liabilities when investing in underserved communities across the US. These regions are called Qualified Opportunity Zones and the tax incentives that come along with them are designed to boost long-term public-private sector investment in low-income urban and rural communities throughout the country.
The Origin of Opportunity Zones
There are major geographical disparities when it comes to private sector investment in the US. The country has been relying on just a handful of places to generate its growth – with five metro areas cranking out as many newly-formed businesses as the rest of the US put together (between 2010 and 2014).
While a handful of cities are surging, much of the rural and impoverished regions of the country are left behind – which is why the concept of Opportunity Zones came about.
Opportunity Zone Map
The US government crafted a new section of the Tax Code (26 U.S. Code § 1400Z) in the TCJA. This created a new type of economic development program called Opportunity Zone Funds, which offer investors big federal tax advantages if they invest in targeted areas referred to as Opportunity Zones.
What are Qualified Opportunity Zones?
An Opportunity Zone (OZ) is a US census tract that has been nominated by its state to be classified as such. The idea is to spur job creation and general economic development in regions that haven’t been able to reap the benefits of the country’s economic recovery.
In order to qualify, a potential OZ must meet the law’s requirements for low incomes or high poverty rates. Opportunity Zones can be found in every state, in five US territories like Puerto Rico, and in Washington DC.
Over 8,700 census tracts, which is about 10% of all census tracts in the country, have scored designations as OZs – and they can range from a few square blocks to massive swaths of land.
Must I relocate in order to take advantage of an Opportunity Zone?
Businesses don’t have to move to an economically distressed area to set up shop, nor do investors have to move to a designated OZ to take advantage of this new tax code. In fact, there is no need to live, work, or run a business in an OZ in order to score the appealing tax incentives.
How do Opportunity Zones benefit investors?
These tax benefits only apply if one invests in a Qualified Opportunity Fund (QOF), which is an investment vehicle created as either a corporation or partnership for investing in eligible property that’s geographically situated in a Qualified Opportunity Zone.
There are two ways that investors can benefit from investing in a QOF:
1. Investors can take previously-earned capital gains (generated elsewhere) and invest them in a QOF to defer paying taxes on those gains. Tax savings depends on how long the QOF investment is held:
– Less than 5 years: No savings. Deferred payment of existing capital gains until the QOF is sold or exchanged
– More than 5 years: 10% exclusion of the deferred gain
– More than 7 years: 15% exclusion of the deferred gains
– More than 10 years: Investor is then eligible for a bump up in the basis of the QOF investment equivalent to its fair market value on the day that the QOF investment is exchanged or sold off (whichever comes first).
2. Investors pay zero capital gains tax on any opportunity-zone investment they hold on to for at least ten years.
Opportunity Zones in Practice
Now, investors can avoid paying capital gains taxes by dedicating themselves to a long-term investment in a community that really needs it. The law is written so that only certain investments can qualify, to ensure that funds flow where they are needed the most.
For example, a real estate fund whose main business involves investments in real estate properties can qualify as a QOF if 90% of the properties in its portfolio are located within Qualified Opportunity Zones.
This way, the government is making sure that their tax incentives are only given to investment operations that can truly enrich a lagging local economy.
So what’s the bottom line?
Opportunity Zone investments aren’t a sure-fire success when it comes to return on investment (ROI), as many factors come into play. It’s best for investors to carefully strategize their QOF investments, as well as look at how other tax incentives (like local or state tax breaks) can be combined with the benefits of investing in Opportunity Zones.