I received another call last week about someone wanting to invest in an Opportunity Zone (OZ). I asked “Why?” and they said, “To save on taxes and make more money.”
OK, I understand and that is a good answer, but what is the plan? How will you save money on taxes? How much will you save? There seems to be a lot of hype around OZs, and for good reason. They could be great, but it has to be the right situation and planned correctly. Because of the hype, and misunderstanding, I wanted to share my understanding on what OZs are and how you, as an investor, can benefit from them.
Legislation passed in 2017 allowing the US Treasury Department to created OZs. In 2018, the information on the incentives were released. Because this is so new, it is highly misunderstood. The idea is to spur economic growth in real estate and jobs by giving tax benefits to investors for investing in businesses or real estate located in certain parts of town. The zones are determined by the state and approved by the federal government. My understanding of this is the only tax benefit is some deferrals and forgiveness of long-term capital gains tax, and there are some hoops to jump through.
First, an individual cannot invest in a piece of property in an OZ. For an investment to qualify for the tax incentives it must invest in the OZ through an opportunity fund (OF). An OF is an entity that is taxed as a corporation or partnership, like an LLC, that invests at least 90% of its equity into OZs. According to the IRS, for an entity to qualify as an OF is simply self certifies by filing a form with the IRS.
The tax benefits can be big. Investors can defer paying taxes on gains if they invest gains into an OF. This works very similar to a 1031 exchange, but it does not need to be a like kind exchange, meaning you could liquidate other investments, like stocks, and defer gains on those. The deferring of taxes gets even better with OZs because the amount you pay on the gain reduces over time. If you invest in an OZ and hold the investment for 5 years you will reduce your gain by 10%, which in turn reduces your taxes. For example, if you have a $50,000 gain from the sale of stocks that you roll into an OZ, after 5 years the report-able gain that you will pay tax on reduces by $5,000 making the taxable gain $45,000. If you hold the assets for 7 years, the gain is reduced another 5%. Making the taxable gain $42,500. In 2026 you will need to pay tax on the differed capital gain whether you sell the asset or not. The big benefit however is when you hold the property for 10 years. After 10 years, you will pay no capital gain on any appreciation on the asset from the day you purchased it. So, if your investment increases in value $100,000 over 10 years and you sell it, you pay $0 in taxes.
Being forced to use OFs to invest in OZs is interesting. From what I can tell, it is done this way to attract larger investments for the largest impact, but I did not find anything saying you cannot set up your own OF to invest in a single property in an OZ. These benefits are big, but the way I see it, it only makes a good deal better. I would not specifically invest in an OZ just for the tax break.
Myths of Opportunity Zones: Here are the two most common myths about opportunity zones that I hear:
I can roll capital gains into OZs, hold the property for 10 years and never pay tax on the gain.
It is true that you will never pay tax on the capital gains from the original investment after 10 years, but you will need to pay taxes on the gains you rolled over in tax year 2026. The gains that you roll into an OZ is simply differed and will reduce over time, but it will never be eliminated.
I can buy a rental in an OZ for big tax savings.
There are two reasons this won’t work. One of the hurdles to OZ investing is that you need to invest through a OF. Once you identify an investment you will need to set up a separate LLC, partnership or corporation to invest in that property and then notify the IRS that your entity qualifies as an OF.
A much more confusing hurdle is substantial improvement. According to IRC Sec. 1400Z-2(d)(2)(D)(I), qualified OZ property held by a qualified OF must satisfy one of the following requirements:
The original use of qualified opportunity zone property commences with the qualified opportunity zone fund, or
The qualified opportunity zone fund substantially improves the property.
The way I understand this is that if you purchase a property you will need to either build new (new original use) or make major improvements. There was recently clarity on the definition to “substantially improves.”
To qualify for substantially improves, you will need to make improvements that doubles your basis (make improvements that equal the amount paid for the asset) in any 30-month period while the asset is owned. The basis does subtract the land value, so the improvements needs to equal the value of the improvements only. For example, let’s say you buy a rental for $100,000. According to the county assessor the value of the land is $20,000. In order to qualify for the tax incentive, you will need invest another $80,000 into the property within a 30-month period at some point in the next 10 years before you can sell the asset.
So, what’s the strategy?
The obvious strategy is to buy land in OZs and build to hold. Other strategies for real estate investors could be to buy and scrape to build town-homes or condos. In those cases, you will want to hold on to a few of the units as rentals for at least 10 years. Another option that I can see some creative investors taking advantage of is accessor building units (ADUs). These are small out buildings or additions used as additional units or apartments. These are becoming more popular with the boom in Airbnb in many areas, you don’t need to be zoned for multifamily to build them. Because of the regulation on short term rentals, you may need to rent these out as long-term rentals, but the number could still work. I can see if you buy a single-family house in need of repair, by the time you rehab the house and build an ADU you could qualify for the tax incentive.
To see a map of the OZs in your area you can visit the US Treasuries site here.