Most of you reading this have probably not previously heard about Opportunity Zones. Opportunity Zones are areas designated by each state that are “distressed” areas, although many happen to be in downtown areas. As a part of the Tax Cuts and Jobs Act of 2017, the federal government offered tax breaks to investors who invested in specific types of projects in Opportunity Zones. Most people don’t have access to buying and developing properties in Opportunity Zones so many developers started projects and allowed individual investors to invest in these projects while receiving the same tax benefits. In order to receive the Opportunity Zone tax benefits, you must have a capital gain that you are trying to offset. The gain could be from any source such as the sale of your primary residence, the sale of an investment property, the sale of stock, or any other gain.
Here is a summary of tax breaks that you get from investing in a Qualified Opportunity Fund:
- Tax deferral of your gain until tax year 2026. For those who invested prior to December 31, 2021 also received a 10% reduction in their gain. Unfortunately, if you invest now, you won’t get the reduction.
- Tax-free returns on income received after 10 years from the close of the fund invested in.
Most states participate in the same tax benefits as the federal tax benefits above. However, if you live in California, you will get the federal tax benefits above but not any of these benefits on state taxes.
While the above sounds good, there’s a few things that most people won’t tell you that really makes some of these funds quite attractive. The following are some of the benefits that will get with many OZ funds but not all, so it’s imperative to choose a fund that meets your investment and tax goals.
- When you own real estate for investment purposes, you may get to depreciate the structures on the property. This means you get to reduce your income by the depreciation. However, when you sell the property, you have to declare the excess depreciation you took and pay ordinary income on that depreciation recapture. With a Qualified Opportunity Zone Fund, you may get a pass-through depreciation over the 10 years, effectively reducing the income on your personal taxes. When the property is sold after 10 years, you won’t have to pay depreciation recapture
- Most funds will pay back most of your investment after the first few years after they refinance the completed project and so your capital is not actually tied up for 10 years
If you are selling an income property, you also have the opportunity to do a 1031 Exchange (see the article on 1031 Exchanges). A 1031 is a great option to defer taxes but there are some differences from Opportunity Zones. With a 1031, you will need to purchase replacement properties in amount equal to or greater than the property you sold to get the full tax deferral of the gain. With Opportunity Zone Funds you only need to reinvest the gain into the fund. In addition, there is no 45 day identification period like there is with 1031’s, which is typically the most difficult part of a successful 1031. OZ Funds can also be used in conjunction with 1031’s but it can be more complicated and many advisors don’t know the nuances of doing both together.
Typically, you have 180 days from the date of your gain to invest into an Opportunity Zone Fund, but if your gain is held in a pass-through entity and you will get a capital gain on your K-1, you may have a lot longer.
I have invested in a quite a 1031 replacement properties and Opportunity Zone funds. Email me if you have any questions. All of my knowledge is derived from my experience as an investor. I am not a tax professional and so this is for informational purposes only and should not be considered tax advice.