Opportunity zones generally represent economically distressed communities that are in need of investment and revitalization. Created under the Tax Cuts and Jobs Act of 2017, the purpose of opportunity zones is to spur economic growth and create jobs by incentivizing investment in these regions.
- Opportunity zones generally represent economically distressed communities that are in need of investment and revitalization.
- To incentivize investment in low-income communities, the federal government created qualified opportunity zones and with them, a host of tax benefits available for those who invest via a qualified opportunity fund.
- The five-year holding period on qualified opportunity funds, which would trigger the 10% adjustment to the amount of the investment, was available for investors who invested in qualified opportunity funds through Dec. 31, 2021.
How Are Opportunity Zones Created?
Low-income communities, as well as certain neighboring areas, are defined by population census tracts and can qualify as an opportunity zone. State governors nominate a limited number of eligible tracts for official designation. The certification and designation of an opportunity zone comes from the secretary of the treasury via their delegation of authority to the Internal Revenue Service (IRS). Detailed information on the eligibility criteria for census tract designation and the nomination and designation process can be found on the IRS website.
Where Are Opportunity Zones Located?
There are 8,764 opportunity zones in the U.S., which represent 12% of all census tracts. Many of the regions designated as opportunity zones have suffered from a lack of investment for decades and can be found on an interactive map shown on the U.S Department of Housing and Urban Development website. Just over 23% of opportunity zones are in rural areas.
How To Invest in An Opportunity Zone
Investors in a free market can allocate capital to any asset class, geographic region, or sector that they choose. With that said, factors such as tax incentives, demographics, seasonality, ethical ideology, and growth prospects often play a key role when it comes to narrowing down investment choices.
To incentivize investment in low-income communities, the federal government created qualified opportunity zones and a host of tax benefits available for those who invest in them via a qualified opportunity fund. For those unfamiliar, a qualified opportunity fund (QAF) is an investment vehicle, such as a corporation or a partnership, that is organized for the purpose of investing in assets within qualified opportunity zones.
For a corporation or partnership to become a qualified opportunity fund it must self-certify by annually filing Form 8996 with its federal income tax. Once designated, qualified opportunity funds must invest at least 90% of their assets in designated opportunity zones to be eligible for tax benefits.
Qualified opportunity funds can invest in both real estate and businesses located within opportunity zones if they meet certain conditions. For example, real estate investments within an opportunity fund must be new or substantially improved. Purchases of existing real estate without making major improvements are not allowed. Substantial improvement to a real estate investment means that the opportunity fund invests at least the amount equal to the cost of the building and it is completed within 30 months.
Tax Advantages of Investing in Opportunity Zones
The primary tax benefit for investors of qualified opportunity funds is that they can defer tax payments on capital gains realized from prior investments. More specifically, if an investor allocates capital gains from a prior investment into a qualified opportunity fund within 180 days from the sale date, then that person is eligible to defer tax payment on the gain until the opportunity fund is sold or Dec. 31, 2026, whichever comes first.
Investors of qualified investment funds can also reduce their tax burdens even more by holding onto their investments for at least five to 10 years. If a qualified opportunity fund is held for at least five years, then there is a 10% exclusion of the deferred gain. If held for at least seven years, the 10% exclusion shifts to 15%. Unfortunately, investors who have yet to invest in opportunity funds will be unable to take advantage of the 15% exclusion since the tax on the deferred gain is payable by Dec. 31, 2026, which is less than seven years away. The deadline for the five-year holding period on qualified opportunity funds has also passed; it was available for investors until Dec. 31, 2021. Investors who hold their investments in qualified opportunity funds for at least 10 years are eligible for an adjustment to the cost basis of the investment to reflect the fair market value on the date that the investment is sold or exchanged. As a result, due to the adjustment to the basis, gains made from the appreciation of qualified opportunity funds are exempted from tax payments.
Criticism of Opportunity Zones
Opportunity zones and the tax benefits associated with qualified opportunity funds have received their fair share of criticism since being introduced in 2017. Some critics suggest that opportunity zones and associated investments are more about tax planning for the rich than making a meaningful long-term impact in economically disadvantaged regions across the country. According to the U.S. Environmental Protection Agency (EPA), data about opportunity zones are clear that most of the census tracts suffer from a lack of ongoing public and private investment. As a result, opportunity zones may lack key infrastructure or other assets that investors seek to ensure productive returns on their investments. The differences between various opportunity zones could mean that only a small portion of opportunity zones will be the beneficiaries of investment and long-term change.
Under some circumstances, the tax advantages associated with opportunity zone investments are undoubtedly worth a closer look. However, given the complexities around eligibility, funding, and timing, it is probably best to consult with a tax expert who specializes in this type of investing. During a consultation with a qualified expert, it may also be prudent to discuss how investing in opportunity zones could be complemented with other types of tax benefits such as charitable giving, the Low-Income Housing Tax Credit Program, the New Markets Tax Credit, historic tax credits, and installment sales.