What are Opportunity Zones and How Do They Work?
- Posted: February 4, 2019
- Posted by: Travis Lynk
- Last Reviewed: February 27, 2019
The creation of the Opportunity Zones program was one of the least publicized parts of the 2017 Tax Cuts and Jobs Act when it was first announced. As taxpayers and community leaders learn more about the program’s tax advantages and economic development potential, interest in the program is growing exponentially.
The Opportunity Zone program seeks to stimulate private investment in economically distressed neighborhoods through generous capital gains tax incentives. The program aligns investor goals with the goals of residents and leaders of disadvantaged communities in a mutually beneficial way.
It is important to understand the basic framework for the Opportunity Zone program, how it works, and how to take advantage of the tax incentives it creates.
What are Opportunity Zones?
The 2017 Tax Cuts and Jobs Act established criteria for designating qualifying low-income census tracts as Opportunity Zones. There are more than 8,700 qualified Opportunity Zones across all 50 states and five U.S. territories.
Governors were given until April 2018 to identify and nominate census tracts that met the criteria for Opportunity Zones. The IRS, which is responsible for program oversight, established the following criteria for Opportunity Zones:
- A poverty rate of 20% or higher
- Median family income of 80% or less of the statewide median for non-metro zones, or the overall median family income for Opportunity Zones located within metropolitan area
Why Were Opportunity Zones Created?
By some estimates, there is over $6 trillion in unrealized capital gains held by U.S. taxpayers. Legislators wanted a way to tap into the economic potential of this immense market to revitalize America’s low-income communities. They landed on capital gains tax incentives as a mechanism to stimulate long-term investment without the costly and restrictive regulatory framework of existing programs such as the Low-Income Housing Tax Credit and the New Markets Tax Credit programs.
The Opportunity Zone program is not a rigid tax credit structure but a program governed by statutes in the IRS code that alter the tax treatment of capital gains.
Opportunity Funds, the investment vehicles for the Opportunity Zone program, are self-certifying entities that do not require approval by a government agency. They are privately managed funds with the flexibility to choose the type and location of the properties in which they wish to invest. There is no limit on the number of Opportunity Funds that can be created under the program, and no limit on the capital the funds can invest.
How Do I invest in Opportunity Zones?
Opportunity Funds are governed under Section 1400Z-2 of the Internal Revenue Code. A fund must be organized as a corporation or a partnership with the objective of investing in qualified Opportunity Zone property. The fund must invest 90% of its capital in qualified Opportunity Zone property to take advantage of the tax incentives.
Qualified Opportunity Zone property is defined as
- Business interest in an organization conducting all or most of its operations within a qualified Opportunity Zone
- Real property, either existing or anew development, within a qualified Opportunity Zone
Opportunity Funds investing in real estate have 30 months to complete any construction or improvements on Opportunity Zone property, and any improvements on existing structures must be equal to or greater than the acquisition cost of the building itself.
Opportunity Funds must meet other requirements depending on the type of investment they choose, but all must demonstrate that at least 90% of the fund’s assets are invested in qualified Opportunity Zone property. The property must be acquired after December 31, 2017.
What are the Tax Advantages of Investing in Opportunity Zones?
There are substantial immediate and long-term capital gains tax advantages for taxpayers investing realized gains in Opportunity Funds. Taxpayers have 180 days after the sale or exchange of a qualifying asset to invest realized capital gains into an Opportunity Fund to qualify for the tax incentives. Capital gains tax payments are deferred for investors who hold their Opportunity Zone investments through December 31, 2026, or until the investments are sold, whichever comes first.
Capital gains tax liability is reduced by 10% for investments held for five years. A further 5% reduction, for a total of 15%, applies after seven years. Investments held for at least 10 years qualify for permanent exclusion from any capital gains tax liability on those Opportunity Fund investments, incentivizing long-term deployment of capital in qualified Opportunity Zones.