If you’re an investor in real estate, or really anything, you want to be able to maximize your profit. If you can be part of community development, that’s even better. The tax code now provides you the opportunity and incentive to do both with the creation of Opportunity Zones.
This article will go over the basics and advantages of Opportunity Zones and why they might be worth looking at if you’re considering buying an investment property.
What Are Opportunity Zones?
Opportunity Zones are areas that have seen significant economic distress. Certain new investments in these communities qualify for a number of tax benefits.
Created as part of the 2017 Tax Cuts and Jobs Act (TCJA), Qualified Opportunity Zones (QOZ) are meant to spur investment in areas that have struggled economically by setting up special tax treatment for investors in these areas.
Governors nominate communities, typically from low-income census tracts, to become Opportunity Zones. Requests are reviewed and approved by the Secretary of the Treasury who has delegated authority to the IRS. The U.S. Department of Housing and Urban Development (HUD) administers the program in consultation with several other government agencies.
In addition to Opportunity Zones, the TCJA also created opportunity funds which are investment resources designed to facilitate economic opportunity and free up capital to be used in Opportunity Zones. We’ll have more on these in a minute.
Where Are Opportunity Zones Located?
As of this writing, there are 8,764 Opportunity Zones within the U.S. The areas run the gamut from urban to suburban to rural in terms of population size. To see which areas are eligible for incentives under the program, check out HUD’s QOZ map.
How Do Opportunity Zones Encourage Private Investment?
Private investors are encouraged to put their capital in Opportunity Zones through a series of tax incentives. Let’s run through them.
Temporary Tax Deferral
You have the ability to temporarily defer taxes on capital gains and gains on the sale of business property if you invest those gains in a Qualified Opportunity Fund (QOF). The deferral lasts until the investment in the Qualified Opportunity Zone is sold or December 31, 2026, whichever comes first.
In order to qualify for the deferral, gains have to be reinvested within 180 days of the day they are recognized as taxable income.
Step Up In Basis
The longer you hold onto your property in a QOZ, the more you can increase the basis under which the fair market value of your property is calculated for the purpose of taxes. This allows you to lessen the taxable gain associated with the sale of property within the zone.
Under HUD rules, there’s a 10% step up in the basis of your QOF investment if it’s held for at least 5 years. At 7 years, the increase in the basis of your investment is 15%. Let’s run through an example to show how this works.
Let’s say you buy a property for $300,000 and hold it for 5 years before selling it at $400,000. Normally, capital gains on the sale would be $100,000, but with a 10% step up in the basis, you would only be paying taxes on a capital gain of $90,000. If it were held for 7 years, there would be a 15% increase in the basis and the taxable capital gain would be $85,000.
Permanent Exclusion From Taxable Income
if you hold onto an investment in a QOF for 10 years or more, any appreciation on the investment can be excluded from your taxable income. Because of this, only the amount of your initial investment is taxable. It’s also less 15% because of the basis increase. This makes for a huge tax advantage and helps make your investment even more lucrative. Let’s do a quick example.
If you have a $500,000 capital gain put into an opportunity fund that is sold 12 years later for $1.2 million, you only pay tax on 425,000. Assuming you were in the highest income bracket at a long-term capital gains tax rate of 20%, your tax bill would be $85,000. The other nice thing is that the $700,000 additional gain from the opportunity fund investment is tax-free because it was held for at least 10 years.
What Are Opportunity Funds?
Opportunity funds, also called qualified Opportunity Funds or QOFs, are those that invest 90% of their capital in Qualified Opportunity Zones. This is a standard that’s checked for compliance every 6 months.
In order to be considered a qualified investment, the Opportunity Fund can invest in companies operating in the area of the opportunity zone. Examples of eligible types of investments would be stock purchases, taking interest in a partnership or in business property in the area.
In addition to the tax benefits, investing in these opportunity funds can be a great way to help build on the economic growth of a local community which has some catching up to do.
What Are The Tax Benefits Of Investing In Opportunity Zones?
The tax benefits for investors and developers in opportunity zones are numerous:
- Taxes can be deferred on the invested capital gain until the earlier of December 31, 2026 or when your opportunity fund investment is sold.
- There is a reduced tax basis on the invested capital gain of 10% if you keep it in the opportunity fund for at least 5 years and an additional 5% if it’s left in the fund for 7 years.
- If you keep the capital gain invested in the opportunity fund for at least 10 years, only the initial investment is taxed and any appreciation on the investment isn’t taxable.
- You can invest any capital gain in an Opportunity Fund to take advantage of the tax benefits.
Let’s run through an example of how this works from a tax perspective in three different scenarios.
If Joanna invests a $200,000 capital gain in a qualifying opportunity fund and holds the investment for 5 years before selling it at a price of $250,000, she pays $46,000 in taxes at the highest long-term capital gains tax rate after accounting for a 10% increase in the basis. (0.2 × $180,000 + 0.2 × $50,000). The basis increase means a $4,000 savings on taxes.
If held for 7 years, the tax basis increase accounts for a 15% savings. Holding everything else constant, this means the tax payment would be $44,000 ($170,000 × 0.2 + $50,000 × 0.2). The tax savings from the increased basis would be $6,000.
If Joanna held the property for 10 or more years, she would pay $44,000 in taxes, but she’d also realize $56,000 in tax savings because not only is she saving 15% based on an increased tax basis, but the appreciation gained after the initial investment is no longer taxable.
Before undertaking any investment or tax avoidance strategy, please consider your situation carefully. Consult a financial advisor and/or tax preparation professional.
What Are The Benefits To The Opportunity Zones?
The goal of Opportunity Zones and the Opportunity Funds they spawn is to benefit areas that are economically distressed by attracting private investors to bring capital to bear and invest in the area. This has several potential benefits:
- More tax dollars come in from businesses investing in the area. Additionally, your residential tax base could grow as people move to the area to be closer to where they work.
- The additional tax dollars could be used to build up infrastructure and services in the area. This in turn would help make moving to the area more attractive for those looking to relocate.
- From a business or development perspective, the tax benefits themselves could make Opportunity Zones attractive targets for expansion.
- Because of the tax benefits associated with investing, businesses may find it easier to attract capital from others.
Opportunity Zones Are A Golden Opportunity For Real Estate Developers And Investors
Investing in Opportunity Zones allows you to defer and even reduce the amount that would otherwise be owed on capital gains tax. Best of all, if held for 10 years, no tax is owed on the appreciation in value of the property.
In order to invest in an Opportunity Zone, you have to form an Opportunity Fund or invest in one that already exists. To qualify, 90% of the capital from the fund has to be invested in the Qualified Opportunity Zone.
One of the things you can invest in and take advantage of the tax benefits for is real estate. Check out this article for the basics of buying an investment property. If you’re ready to get started, you can apply for financing with Rocket Mortgage®.
As always, weigh your options and consider talking to a financial advisor or tax professional before undertaking a major financial transaction or a new tax strategy.