Tax Benefits of Opportunity Zone Investment

As part of the Tax Cuts and Jobs Act of 2017,^[1] the federal government designated some underserved communities as “qualified opportunity zones.” The aim of opportunity zones is to provide benefits to these communities by giving real estate investors tax incentives that encourage community development.

But what exactly are the tax benefits of investing in opportunity zones? We’ll explain how opportunity zones work and how investors can benefit the community, such as affordable housing, while taking advantage of the available tax incentives.

What Are The Tax Benefits of Investing in Opportunity Zones?

Before we dive into the main tax benefits of investing in qualified opportunity zone property, it’s important to note that there are some caveats of these tax breaks, including:

• The tax benefits of opportunity zones only apply to capital gains tax: Some investment properties may produce ordinary income (like rental income, for example). And typically, any ordinary income generated through an investment in an opportunity zone or opportunity fund will be taxed by the IRS at the taxpayer’s normal tax rate.

• They require a one-to-one purchase and development spend: To take advantage of the tax benefits of a qualified opportunity zone investment, you’ll have to match the purchase price of the properties in renovations. That is, you’ll have to invest as much in developing the properties as you spent in purchasing them. When you meet that threshold, you’ll be eligible to receive the tax benefits.

Opportunity zones provide three main tax benefits for investors: tax deferral, step-up in basis and tax-free status after 10 years.

Tax deferral

The first benefit is the tax deferral of capital gains. These capital gains will need to be reinvested into opportunity funds or opportunity zones within 180 days to claim the tax deferral.^[2] The tax deferral on the reinvested capital gains can be used until the end of 2026 or until the asset is sold.^[2]

Step-up in basis

As an investor who chooses to invest in an opportunity fund, you will receive a 10% step-up in basis after 5 years of investing in the fund before 2026. Investors can enjoy an extra 5% step-up basis after 7 years of investing in the fund before 2026.^[2]

With these timelines in mind, real estate investors would have needed to invest in an opportunity fund before December 31, 2019, to capitalize on the maximum step-up basis of 15%.

Here’s a closer look at how this would work in practice:

Let’s say you sell an asset for $2 million, which creates a $1 million capital gain. After the creation of that capital gain, you choose to invest the funds into an opportunity fund within 180 days of the sale to avoid capital gains tax.

With the step-up basis of deferred gains, you would be given a $100,000 basis, which is 10% of the original $1 million capital gain deferred. Of course, this would only happen once you reach the 5-year mark on the investment. If you chose to hold onto this investment for 7 years, then you would receive another $50,000 on a step-up basis. Altogether, this creates a total of $150,000, which amounts to 15% of the original capital gain.

At this point, you cannot take advantage of the full 15% step-up basis because the timeline ends in 2026. However, you can still take advantage of the possibility of a 10% step-up basis.^[2]

After 10 years, tax-deferred becomes tax-free

We mentioned that the goal of opportunity zones is to encourage long-term investing. This incentive is a dream come true for a long-term investor.

After keeping their investment in the opportunity fund for at least 10 years, let’s say the investor decides to sell. At that point, the investor would enjoy a permanent exclusion from taxable income for the capital gains invested in an opportunity zone or opportunity fund.

Keep in mind, this only pertains to a qualifying investment. You’ll need to make proper deferral requests along the way to maximize this opportunity.

How Do the Opportunity Zone Tax Benefits Work?

There are many tax benefits wrapped up in opportunity zone investments. Let’s take a closer look at how these tax benefits might apply in your situation.

Rental property owners

As a rental property owner, here’s how you could take advantage of the tax benefits:

In one example, let’s say that you’re a real estate investor who already owns several properties. You decide to sell these properties and reinvest in a multifamily unit within an opportunity zone. You complete the transaction within the appropriate timeline set by the IRS. Once the transaction is complete, you manage the property yourself.

As the investor who manages the property, you will have to report your rental income on your tax return as ordinary income (in most cases). Remember, this ordinary income will be taxed at your normal tax rates and collected by the IRS accordingly.

However, the capital gains made by the property will receive a different tax treatment. With that, you can enjoy tax deferral options until 2026 on the capital gains created by the property. 

At the 5- and 7-year marks, you’ll be able to tap into the step-up basis opportunity. 

Finally, at the 10-year mark, you can sell the property and enjoy a tax-free transaction on the portion of capital gains created by your initial investment.

Let’s explore a second example. In this case, a real estate investor moves property into an opportunity fund that is managed by someone else while the investor enjoys retirement. The manager of the opportunity fund is allowed to renovate and manage the property.

The rental income created through the opportunity fund would be considered ordinary income and taxed accordingly. Beyond that, you would be able to take advantage of tax deferral options until 2026 on the capital gains created by the property. 

At the 5- and 7-year marks, you’ll be able to tap into the step-up basis opportunity. These could amount to a total of 15%, but it depends on when you begin the investment. 

Finally, at the 10-year mark, you can sell the property and enjoy a tax-free transaction on the portion of capital gains created by your initial investment.

Capital gains holders

As an investor, you can place cash, or properties, into an opportunity fund to enjoy tax benefits. No matter which you choose, you can defer the capital gains created through the appreciation of the asset.

When you leave the initial investment in an opportunity fund for 10 years, and it appreciates, there will be no new capital gains to consider. As an investor, you will only have to pay capital gains tax on the original gain. But even that can be reduced by up to 15% through the step-up in basis option.

What’s the Difference Between Investing in an Opportunity Zone (Or Fund) and a Section 1031 Exchange?

When you invest in an opportunity zone or fund, you can tap into tax-deferral options. Additionally, you can enjoy tax-free growth in perpetuity if you reach the 10-year milestone in your investment.

Unlike an opportunity zone or opportunity fund investment, Section 1031 exchanges only defer taxes so the investment can continue to grow. But outside of an opportunity zone, capital gains taxes will come due whenever the property is sold.

For example, let’s say you invest $100,000 in an opportunity fund. You enjoy the tax deferral options along the way. But you choose to hold onto the investment for 10 years. At that point, you can sell the property and will only have to pay taxes on capital gains created by your initial investment. Plus, even these can be reduced through a step-up basis of up to 15%.

On the flip side, if you pursue a Section 1031 exchange, you’ll have to pay capital gains taxes when you eventually sell your property.

Who Should Consider Investing In An Opportunity Zone Or Opportunity Fund?

The decision to invest in a designated opportunity zone or opportunity fund can create a tax shelter for significant capital gains. With an opportunity zone investment, you will need to be more hands-on. But an opportunity fund investment could be a good fit for more passive investors.

The major downside to either avenue is the long-term capital commitment to capitalize on the tax benefits. But if you have significant capital gains that you’d like to shelter, then the illiquidity could be a sacrifice you are willing to make.

Active real estate investors

Active real estate investors, such as rental property owners or real estate developers, can invest directly in opportunity zone properties to enjoy the tax benefits.

Passive investors

Real estate investors also have the option to create opportunity funds through the transfer of cash or property. As a passive investor, you can choose to invest through opportunity funds. With that, you will enjoy the benefits of deferred capital gains. Plus, you’ll be able to invest in the long-term growth of your community.

Investing In Opportunity Zones: Do Your Research

Real estate investment can be a great way to make money in the long term. But investing in real estate can be a risk if you don’t take the time to learn about best practices. With well over 8,000 opportunity zones,^[3] it’s critical to research your choices to make the best decision for your investment goals.