- Opportunity zones are economically distressed communities designated by the IRS.
- Accredited investors can buy into funds that invest in these areas and receive tax benefits.
- The program is intended to spur economic development, but it can take time to see an impact.
In an ideal world, investors could find attractive deals, save money on taxes, and help the communities they put money into. But is it really possible to achieve all of that at once? That’s what the US government is trying to do with opportunity zones.
However, meeting opportunity zone requirements in order to gain tax benefits can be tricky, and these deals aren’t the right fit for everyone. But for some, particularly real estate investors, opportunity zones hold allure.
What is an opportunity zone?
An opportunity zone is an “economically distressed” geographical area, according to the IRS. Investors can allocate money into qualified opportunity zones (QOZs) and receive tax benefits, while the community gets a boost to its economy and job market.
The tax benefit is particularly attractive to real estate investors with unrealized gains. Normally, when gains are realized (ie, you sell an investment for more than you bought it for), you’d face capital gains taxes. But opportunity zones enable investors to roll those gains into new investments, deferring and potentially reducing capital gains taxes.
History of opportunity zones
The QOZ program was created as part of the Tax Cuts and Jobs Act at the end of 2017. At the time, US households and corporations had roughly $6 trillion in unrealized gains, according to the Economic Innovation Group.
“I think the government thought that would entice people to realize those gains and redeploy them into distressed areas and make improvements to those areas,” explains Jeffrey Bowden, co-leader of the tax department at Anchin, an accounting firm. He is also a member of Anchin’s real estate industry group and financial services practice.
In many cases, opportunity zone investments involve commercial and residential real estate, but they can also include other projects, such as infrastructure or small businesses. States, territories, and Washington DC can nominate opportunity zones to be approved by the IRS.
By April 9, 2018, the IRS designated the first set of QOZs across 18 states. Now, there are about 8,700 communities designated as QOZs across all 50 states, Washington, DC, and five US territories (American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and US Virgin Islands).
In April 2022, bipartisan legislation was introduced to extend the deadline to invest in opportunity zones from the end of 2026 to the end of 2028. But that bill has not yet passed.
Opportunity zone map
You can find QOZs in your area or search across the US, including its territories, via a map from the Department of Housing and Urban Development.
As the map shows, opportunity zones are distributed far and wide, and are prevalent in suburban and rural areas. For example, most of the North Slope Borough of Alaska, one of the more remote areas of the country, is located in an opportunity zone.
Here’s an additional map showing the number of opportunity zones by state across the US.
Qualified opportunity funds
To invest in an opportunity zone, the money needs to be allocated through a qualified opportunity fund (QOF). These investment vehicles need to be set up as corporations and partnerships as part of the IRS filing requirements to receive tax benefits.
In theory, anyone can set up a QOF, but opportunity zone rules can be complex, so these funds tend to be managed by professionals.
“There’s a lot of nuances that need to be followed,” Bowden says about creating a QOF. “You can easily get tripped up.”
One requirement is that at least 90% of a QOF’s assets need to be held within an opportunity zone. QOFs can hold stock, partnership interests, or property in a business located within a QOZ. Direct investment in certain types of businesses is excluded, such as golf courses, liquor stores, and gambling facilities. However, a QOF could own property that is then used by these types of businesses, as long as it passes a few tests, including that it leases less than 5% of its assets to these enterprises.
QOF investments also need to meet the substantial improvement requirement for existing property. Rather than just investing in an existing building and hoping that you generate returns from a rising real estate market, you need to put more into improving the property than what the initial investment was worth.
“You need to increase the basis of a property, excluding the land value, by [over] 100%,” Bowden explains. “A simple example: if I bought a building for $100, and 20% was allocated to land, that means the basis of the building is $80. That means you need to put in $80.01 in substantial improvements to qualify.”
How to invest in QOFs
While some funds have relatively low investment minimums (eg, $500), they’re generally geared toward accredited investors. In other words, QOFs are reserved for large investments from high-net-worth and institutional investors. The National Council of State Housing Agencies (NCSHA) publishes a list of publicly announced QOFs. Investors who are interested in QOFs can speak with their financial advisor or contact the fund directly.
QOF tax benefits
Investing in an opportunity zone allows for the deferral of federal capital gains taxes. Rather than paying taxes stemming from the sale of real estate or other investments in a QOZ an investor could roll that money into a QOF.
If all the requirements are met, then an investor can gain benefits like a 10% step-up in cost basis if the investment is held for at least five years, plus another 5% if it’s held for at least seven years. The higher the cost basis of the opportunity zone investment, the less the realized gain would be, meaning the investor would owe less in capital gains taxes.
For example, if your cost basis was $1 million and you sold an investment for $2 million, you would have a $1 million gain. But if your cost basis was $1.1 million, you would be taxed on a $900,000 gain instead.
But keep in mind that capital gains taxes can be deferred only until the end of 2026, unless the government adds an extension. To meet the five-year holding rule, you would’ve had to invest before 2022.
Still, investors can benefit from current investments in opportunity zones. Another tax benefit is that if you hold the investment in an opportunity zone for at least 10 years (and sell before 2047), any of those gains could be eliminated. For example, if you invested in a building that doubled in value from $1 million to $2 million, you could potentially avoid taxes on that $1 million gain.
“If you were looking to do the deal anyway, and you can take advantage of the opportunity zone, I think the benefits that the government has provided are pretty substantial,” Bowden says.
While the tax benefits of opportunity zones can be appealing, that doesn’t make every opportunity zone investment a home run.
Whether you’re dealing with a QOF with high fees, or the investment simply isn’t as financially strong as other places where you could allocate your money, there are many reasons why an opportunity zone investment might not be the right fit.
“An opportunity zone is not going to make a bad deal a good deal, it’s going to make a good deal a better deal or a great deal, potentially,” Bowden says.
Because of the long time period that you need to hold investments to reap the tax benefits, your investment is relatively illiquid. Plus, since QOFs are geared toward accredited investors (generally those with a net worth of more than $1 million), the barrier to entry is high.
The bottom line
Opportunity zones are somewhat of an experiment. The initial program was designed to run through 2026 and provide tax benefits to investors who put money into redeveloping low-income areas. That can be great for some investors who want to reduce their capital gains liabilities, but it’s less clear — at least so far — what the lasting impact is on the communities.
Going forward, it’s possible that lawmakers will renew or redesign opportunity zones to increase their impact.