Updated: May 21
Since the Investing Opportunity Act was established in 2017 the Opportunity Zones and Opportunity Funds were overlooked by many and well-taken advantage by the wealthy. It took a while for smaller real estate investors to understand the advantages found in the act and the capability to defer capital gains.
What are Opportunity Zones?
Opportunity Zones were created with the purpose to encourage private investments into distressed communities. The reason being that taxpayer dollars wouldn't make enough of an impact in these communities and the government understands the need these communities have for further funding. Taxpayers who invest in these zones can benefit from capital gains tax incentives due to this legislation.
With this law being relatively new to the majority of investors, we are here to share some of the highlights about investing in opportunity zones and the impact they could have on your portfolio.
To start off...
There are opportunities found all over the 50 States in the US and its territories. Some of our favorites, Marion County in Ocala, FL and areas in Kissimmee, FL.
The rules assign up to 25% of low-income neighborhoods that meet income qualifications, however, in a similar manner there are also rules where 5% of non-low income tracts that meet other income and geographic requirements in each area as Opportunity Zones. In areas where there are fewer than 100 census regions, up to 25 of those census areas can be designated as such opportunities. Once an area is designated as an Opportunity Zone they are allowed to retain it for 10 years. Today, there are more than 8,700 opportunity zones designated in the U.S. and its territories, almost 12% of the areas found in the US Census.
The excerpt of the bill established two new Internal Revenue Code (IRC) sections: IRC sections 1400Z-1 and 1400Z-2. IRC section 1400Z-1 rules Opportunity Zones and IRC section 1400Z-2 rules Opportunity Funds.
How does it work?
The designation of Opportunity Zones is designed to help spur the development of identified communities. In exchange for investing in Opportunity Zones, investors can access capital gains tax incentives available exclusively through Opportunity Zones. To access these tax benefits, investors must invest in Opportunity Zones specifically through Opportunity Funds. A qualified Opportunity Fund is a US partnership or corporation that intends to invest at least 90% of its holdings in one or more qualified Opportunity Zones.
As previously mentioned, Opportunity Funds are governed by IRC section 1400Z-2 and Opportunity Funds can self-certify to the IRS. But each Opportunity Fund is responsible for ensuring that they abide by the guidelines of regulations in order to be able to offer tax incentives. Because Opportunity Zones are intended to stimulate positive growth within designated communities, there are restrictions on the types of investments in which an Opportunity Fund can invest. These investments are called “Qualified Opportunity Zone property,” which is defined as any one of the following:
Partnership interests in businesses that operate in a qualified Opportunity Zone.
Stock ownership in businesses that conduct most or all of their operations within a qualified Opportunity Zone.
Property such as real estate located within a qualified Opportunity Zone.
There are rules that govern each of these three investment options, but the rules for businesses are similar to those of the Enterprise Zone Business requirements. For property such as real estate, the rules are somewhat different. The types of real estate investments allowed under regulations are limited to ensure that the communities are improved with each investment.
Essentially, Opportunity Funds can only invest in the construction of new buildings and the substantial improvement of existing unused buildings. If an Opportunity Fund invests in the improvement of an existing building, it must invest more in the improvement of the building than it paid to buy the building. Whether the building is constructed from the ground up or improved, the development of the building must be completed within 30 months of purchase.
Tax Advantages of Investing in Opportunity Zones
Investors who choose to invest in Opportunity Zones are rewarded with capital gains tax incentives immediately and in the long run.
Think about this. When you divest an appreciated asset, the capital gains from that transaction generate a taxable event. On the other hand, if you place this capital into an Opportunity Fund, you defer and reduce the tax duties from the gains. Not only that... You could qualify to receive tax-free treatment from all future capital gains generated through the funds. Altogether, these incentives can greatly increase the after-tax ROI realized by Opportunity Zone investors.
There are a few criteria you should know:
Investors who reinvest capital gains into an Opportunity Fund can defer paying capital gain taxes on those funds until April 2027 for investments help through December 31st, 2026. Also, the funds must be invested in an Opportunity Zone within 180 days to qualify for this incentive.
Those who hold their Opportunity Zone investment for 5 years prior to December 31st, 2026, can reduce the liability on the deferred capital gain principal invested in the Opportunity Fund by 10%. If the investment is held for 7 years, the liability can be reduced by up to 15%
Those who hold their Opportunity Fund investment for at least 10 years should expect to pay no capital gains taxes on the appreciation of their Opportunity Fund investment. The reason being that Opportunity Zone investments can potentially qualify for complete exclusion from the capital gains tax when the investment is held for 10 years.
Knowing this, investors need to know the timeline of events to take advantage of their Opportunity Zone investments and the tax incentives inherent to them. This is especially important for those who invested in 2019. Nevertheless, with the crisis, we are living and the impact these investments have had in many communities around the US, we expect these benefits to be extended in the future.
Here is a graphical representation of the timeline you should consider.