- The OZ incentive provides three distinct benefits to taxpayers who invest capital gains into opportunity zones, each involving deferral, reduction, or exclusion of taxes.
- Recent macro-economic issues created distinct decision points for OZ investment strategies; previously issued final regulations provide flexibility.
- If the QOF holds lower basis assets when the 10-year period is reached, the OZ investors will have effectively created permanent tax savings from depreciation deductions.
Uncover long-term investments that defer taxes and exclude capital gains.
When the Qualified Opportunity Zone (OZ) incentive was created as part of the 2017 Tax Cuts and Jobs Act, the Treasury Department estimated the program would create $100 billion in new capital investment directed into approximately 8,700 designated census tracts across the United States.
Despite a lengthy process of drafting and finalizing regulations, investments into opportunity zones began soon after the initial census tracts were designated in April and May 2018, and investments continue today.
Benefits of the OZ incentive
The OZ incentive provides three distinct benefits to taxpayers who invest capital gains into opportunity zones:
- Deferral of realized capital gains until December 31, 2026, or earlier if the investment is sold
- Permanent reduction of 10% or 15% in the amount of capital gains recognized on December 31, 2026, provided certain holding periods are met
- Exclusion of gain on the sale of the investment if the taxpayer holds it at least 10 years
The second benefit requires taxpayers to hold their OZ investment for a minimum of five or seven years, respectively, to receive the 10% or 15% permanent reduction in recognized gain on December 31, 2026. Because the recognition date is fixed, the five- and seven-year holding period benefits are not available for investments made after December 31, 2019, and December 31, 2021, respectively.
Although the first benefit was distinctly beneficial in providing taxpayers a tax deferral and a net present value savings of the tax eventually paid, the most valuable benefit of the OZ program is widely accepted to be the exclusion of gain after holding the investment at least 10 years. The OZ program was designed to incentivize taxpayers to make longer-term investments, and the reward for this longer investment period was the elimination of taxes owed on gains realized upon the sale of the investment.
Taxpayers responded positively to the OZ incentive, and it is estimated the program has already created nearly $100 billion of capital investment, with four years left before the program expires.
Explore OZ investment strategies
The macro-economic issues experienced during 2022, including spiking inflation, rising interest rates, tightened lender restrictions, loss of investor confidence, and general uncertainty were certainly felt by OZ stakeholders, creating several distinct decision points requiring actions to be taken on OZ investment strategies.
Investors may be asking if it is better to withdraw their investment and pay the deferred capital gains tax. Sponsors may be asking if an OZ project still has viability in the current economic climate. Many OZ projects undertaken in the early years of the program may have already been completed, stabilized, and sold. Amidst this uncertainty, what questions should OZ stakeholders really be asking?
Thankfully, previously issued final regulations provide answers and flexibility to these decisions. Most OZ projects are funded by taxpayer investments made into a qualified opportunity fund (QOF), or a specially designed holding company, which then deploys the capital raised into a subsidiary entity organized as a qualified opportunity zone business (QOZB), with the QOZB serving as the project operator/owner. In this structure, several options are available when an underlying project is sold or abandoned.
Importantly, any gains realized from the sale of property will be treated as fully taxable to an OZ investor if they have not held their QOF investment for at least 10 years. The 10-year holding period begins when the investor acquires their investment in a QOF, not when the OZ property is acquired, started, or even placed in service.
As a result, the investor's 10-year holding period will almost always be achieved before the project itself has been owned for 10 years. Nevertheless, if the project is sold before the investor has reached the 10-year period, the investor will recognize a fully taxable transaction.
Reinvesting eligible gain allows tax benefits
In most cases, the sale of OZ property is considered eligible gain for purposes of making another deferral election by investing in a QOF, except where property is sold to a related party. This means an investor realizing taxable capital gain can defer the new gain on the sale of the project by making a new and distinct investment into a QOF, keeping in mind the OZ program is presently scheduled to expire and capital gains cannot be invested into opportunity zones unless they are recognized on or before December 31, 2026.
Unless the QOF realizing the gain is liquidated or otherwise makes a distribution to the OZ investor, the investor will need to secure an alternative funding source for making their next new OZ investment. New OZ investments will begin a new 10-year holding period for measuring future tax-free gains.
Although the gain from selling an OZ project before 10 years remains fully taxable, a QOF has the flexibility to retain the cash proceeds and reinvest into other OZ projects within 12 months. Doing so preserves the QOF and the investors’ original 10-year holding period and allows the QOF to continue to make investments into OZ projects that could appreciate and obtain tax-free gain benefits after the OZ investor reaches a 10-year holding period.
This same rule applies to a QOF that receives its capital back from a QOZB in a nontaxable transaction, such as when a QOZB determines to unwind and liquidate before a project has been fully developed. This flexibility is designed to keep the QOF intact while determining the ultimate strategy with respect to its investments.
The provisions granted to QOFs allowing for reinvestment of proceeds received from divested assets are critically important to allowing a QOF to achieve its full potential.
By reinvesting proceeds received by an existing QOF, the investor may continue their 10-year holding period and shorten the actual period for holding a new OZ project. After the investor's 10-year holding period, the investor can continue to enjoy tax-free gains on any assets held by the QOF at that time.
As a result, even though gains realized prior to the 10-year hold are fully taxable, the proceeds from such gains may provide additional capital the QOF can continue to use to create compounded value while the investor continues to hold their investment for at least 10 years. Similarly, a QOF has flexibility to reposition investments by divesting of and reinvesting in different QOZBs, without causing the QOF itself to dissolve.
Additionally, once an OZ investor has held their investment for at least 10 years, they are no longer subject to depreciation recapture upon the disposition of OZ projects or their QOF investment. This is significant, because regardless of whether a QOF has disposed of an earlier investment before the 10-year period has been met, if the QOF holds lower basis assets (such as assets with accelerated depreciation) when the 10-year period is achieved, the OZ investors will have effectively created permanent tax savings from depreciation deductions.
The provisions granted to QOFs allowing for reinvestment of proceeds received from divested assets are critically important to allowing a QOF to achieve its full potential — that is, to be owned by OZ investors for 10 years and allow such investors to realize tax-free gains, the most significant benefit of the OZ program.
QOF investors should maintain close communication with their tax and financial advisors to properly evaluate the tax and financial benefits of holding and divesting of investments in QOFs, disposing of property owned by QOFs, and the overall continuity strategies for their QOF investments.
How we can help
CLA has deep experience across a broad spectrum of potential OZ fund stakeholders, so we can translate how these incentives apply to you. Our team of real estate professionals can help you realize investment opportunities, position yourself for tax benefits, and foster community redevelopment.