What is an Opportunity Zone?
As part of the Tax Cuts and Jobs Act, the opportunity zone provision is designated to encourage investment and economic growth in economically distressed communities, in turn offering federal tax incentives to the taxpayer who invests in a property located in one of these zones.
Section 1400Z-2 allows a taxpayer (1) the temporary deferral of capital gains, to the extent the gains are reinvested into Qualified Opportunity Fund (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than ten years.
To be eligible for this favorable tax treatment, the investment must improve the lives of those living in the opportunity zone by either (1) bringing new business to the zone that creates jobs or expands opportunities, or (2) improving the availability, aesthetics, and value of the zones’ housing options by engaging development projects.
The Life Cycle of an Opportunity Zone Investment
- Initial Investment: A taxpayer realizes an eligible gain that would traditionally be taxed that year as a capital gain. The taxpayer reinvests the gain within 180 days into a QOF and defers the gain for the years of the sale.
- Claim a Deduction: The QOF conducts a Section 162 business, either directly or by holding Qualified Opportunity Zone Business Property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest, provided the subsidiary meets the definition of a Qualified Opportunity Zone Business (QOZB).
- After Five Years: The taxpayer receives a 10% stepped-up basis, meaning the tax-payer can exclude the 10% of the original deferred gain.
- After Holding Interest for Ten Years: The taxpayer may sell the investment in the QOF, or the QOZB may sell its assets, at which point the taxpayer will owe $0 in taxes on the new gain.
- Recognized Deferred Gain: Any remaining deferred gain is recognized on December 31, 2028, unless an inclusion event occurs before that date. Assuming the taxpayer is still holding the investment, the taxpayer must pay taxes on the original gains, after accounting for the stepped-up basis, at this time.
- After an Additional Two Years: A supplementary five percent of the original deferred gain is excluded, for a total stepped-up basis of 15%.