Opportunity Zones were created by the Tax Cuts and Jobs Act in late 2017. This new program was added to the tax code to encourage economic development in low-income communities while providing tax deferment incentives for investors that have unrealized capital gains. Unrealized capital gains are profits existing on paper, resulting from an investment which has yet to be sold for cash, stock, securities or real estate. There is ample opportunity to participate, as there are more than 8,700 designated zones that cover sections of all 50 states, including the District of Columbia and five U.S. territories.
Along with the extensive number of zones, a study conducted by Real Capital Analytics finds that an estimated $6 trillion of unrealized capital gains are eligible to be invested in opportunity zone funds. While not all unrealized capital gains will be invested in opportunity zones, these zones encourage commercial and business real estate development in low-income areas throughout the United States.
To contribute to the economic boom and qualify for the tax deferment incentive, investors must place the unrealized capital gains in a Qualified Opportunity Funds (QOF). QOFs must be certified by the U.S. Treasury Department; organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone property (QOZ); and must hold at least 90% of their assets in the QOZ property. QOZ property includes QOZ stock, QOZ partnership interests and QOZ business property. Another perk worth noting is that investors do not have to live in the opportunity zone to receive the tax benefit.
Once an unrealized capital gain is invested in a QOF, the tax deferment is incentivized by the length of the investment. If an investor holds the investment for 5 years, the taxable amount of the original unrealized capital gain is reduced by 10%. After 7 years, the taxable amount of the original capital gain is reduced by an additional 5%, totaling 15%. No matter how long the investment is held, the original unrealized capital gain must be recognized at the end of the deferral period, December 31, 2026. Appreciation in value after that is permanently excluded. If the investment is held for 10 years, any gain from the original capital gain is not taxed.
As an example: Joe sells an investment of $200,000 in year 2017. Joe has an unrealized capital gain of $50,000. To defer paying taxes on his unrealized capital gain, Joe invests the $50,000 in a Qualified Opportunity Fund.
- If Joe holds his investment for 5 years, until year 2022, his original unrealized capital gain of $50,000 taxable amount is reduced by 10% ($5,000), leaving only $45,000 taxable.
- If Joe holds his investment for 7 years, until year 2024, a total of 15% ($7,500) is no longer taxable of the original $50,000 unrealized capital gain.
- At the end of the temporary deferment period, which is December 31, 2026, Joe must recognize a $42,500 gain on his tax return.
- If Joe holds his investment for at least 10 years, until year 2027, he would not realize any additional capital gain beyond the $42,500 recognized at the end of the deferral period (2026).
This provides significant incentives to invest capital in these Zones and realize profits tax-free. With additional regulations expected in January, NAA/NMHC have filed joint comments to The U.S. Department of Treasury regarding the proposed regulations on the implementation of the new Opportunity Zone tax incentive, to achieve the utmost clarity in the final regulations for our members. If you have any questions regarding Opportunity Zones as the additional guidance is released, please contact Jodie Applewhite, Manager, Public Policy at NAA.