The IRS released its third and final Opportunity Zone regulations at the end of 2019. Here is what you need to know. As I hope you are aware by now, Opportunity Zones were included in the new tax law known as Tax Cuts and Jobs Act of 2017. These zones encourage private sector investment in low-income community businesses which are inside defined census tract lines throughout the United States. See IRS FAQ on Opportunity Zones.
Every Opportunity Zone (OZ) investment has three components: someone with a capital gain (the investor), a fund (called an “Opportunity Fund”), and an investment opportunity (called a “Qualified Opportunity Zone Business”).
If you need a primer, I’d suggest reading Opportunity Zones in Alabama. We have aggregated our prior informational blogs here for your convenience. If you want to know more about the Alabama state incentive changes related to Opportunity Zones, read Alabama adds state incentives to the federal Opportunity Zone plan. Also, check out an interactive map of Alabama’s zones.
High Level Overview
You have a gain from the sale or exchange of property (from just about any source). Take any portion of that gain and invest in a qualified opportunity zone fund (“QOF) within 180 days of the gain occurring. There are, however, a number of critical exceptions to the 180 day rule for pass-through entities like LLCs taxed as partnerships, S-Corporations, or beneficiaries of estates. These investors have either 180 days from the date the partnership had the gain or 180 days from the end of the entity’s tax year, whichever works better for the investor.
You can create your own QOF. To become a Qualified Opportunity Fund, an eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return, or you can invest in someone else’s QOF that has already been established.
You then are allowed to defer any taxes due on that gain through December 31, 2026. Reminder – If you still hold the Opportunity Zone investment on December 31, 2026, you will have to report and pay tax on the deferred gain on your 2026 tax return AT THE THEN CURRENT CAPITAL GAIN TAX RATE. However, you will receive basis in the investment in an amount equal to the gain reported at that time. If you hold the investment for at least 5 years you will receive additional basis equal to 10% of the original deferred gain. If you invested prior to 12/31/2019, if will have enough time to hold the investment for at least 7 years you will receive additional basis equal to 5% of the original deferred gain giving you total basis of 15% of the original gain at that time.
Therefore, if you sell the investment after holding it 7 years but before December 31, 2026 you will only pay tax on 85% of the original deferred gain plus the gain of future appreciation. If you still hold the property after holding it 7 years on December 26, 2026 you will pay tax on 85% of the original deferred gain on your 2026 tax return, permanently eliminating the tax on 15% of the original deferred gain.
If you hold the investment for at least 10 years you will receive a new basis in the investment equal to the fair market value of the investment on the date it is sold. Therefore, holding the investment a minimum of 10 years completely eliminates the gain on any future appreciation.
For example, if you defer a $1 million gain by investing it into an Opportunity Zone fund in 2018 and then sell it for $1.5 million in 2024, you will receive basis of $100,000 in the investment ($1 million times 10%) because you held the investment at least 5 years but less than 7. Therefore, you will only be required to report a gain of $1.4 million instead of $1.5 million in 2024. If you held it until 2025 instead before selling it for the same price, you would have received basis of $150,000 and reported a gain of only $1,350,000 since you held it at least 7 years.
However, if you still hold the investment on December 31, 2026, you will have to report a gain of $850,000 on your 2026 tax return as the deferral period expires at that time. The gain report-able on December 31, 2026 is only $850,000 instead of $1 million because you would have held it at least 7 years on that date and have basis of $150,000 in the investment. In addition, you will receive basis of $850,000 in the investment at that time as a result of the gain recognition so your basis in the investment will include the $150,000 basis for holding it at least 7 years plus the $850,000 gain recognized for total basis of $1 million. Therefore, if you sell the investment for the same $1.5 million after December 31, 2026 but before you hold it 10 years, you will only pay tax on the appreciation of $500,000 because you will have basis of $1 million in the investment and have already paid the tax owed on the $850,000 gain.
Once you have held the investment at least 10 years, your basis will become the fair market value, when it is sold, so therefore appreciation on the OZ investment is tax free.
In short as an INVESTOR, you have three benefits: temporary deferral of capital gains tax, a potential capital gains tax reduction based on your amount invested and holding period, and a total elimination of capital gains taxes on what you make on the Opportunity Fund investment.
Once an investor forms an Opportunity Fund, they must ensure that 90% of their assets are invested in stock or partnership interests of “qualified Opportunity Zone businesses” (or directly into qualified OZ property). Funds must meet the 90% Investment Test twice a year—on June 30 and December 31.
For a deeper dive, I’d suggest reading Final Opportunity Zone Regulations Explained from Opportunity Alabama. Opportunity Alabama is a nonprofit initiative dedicated to connecting investors with investable assets in Alabama’s Opportunity Zones. By using a data-driven approach, we bring investors, opportunities, communities and key institutional supporters together to generate real returns while improving economic vitality and quality of life.
There are many hoops to successfully navigate to take advantage of the tax benefit, but they are worth it from a tax savings perspective. Please contact your JMF tax advisor for more information.