I received another call last week about someone who wanted 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’s a good answer, but what’s the plan? How will you save money on taxes? How much will you save? There seems to be a lot of hype surrounding the OZs, and for good reason. They could be great, but it has to be the right situation and planned correctly. Due to the hype and misunderstanding, I wanted to share my understanding of what OZs are and how you, as an investor, can benefit from them.
Legislation passed in 2017 allows the US Treasury Department to create OZ. In 2018, the information on the incentives was released. Because this is so new, it is very misunderstood. The idea is to stimulate economic growth in real estate and jobs by providing tax benefits to investors for investing in businesses or real estate located in certain parts of the city. Zones are determined by the state and approved by the federal government. My understanding of this is that the only tax benefit is some deferral and long-term capital gains tax forgiveness, and there are some hoops to jump through.
First, an individual cannot invest in property in an OZ. For an investment to qualify for tax incentives, it must invest in the OZ through an opportunity fund (OF). An OF is a tax-paying entity such as a corporation or partnership, such as an LLC, that invests at least 90% of its capital in OZ. According to the IRS, for an entity to qualify as an OF it simply must self-certify by filing a form with the IRS.
The tax benefits can be great. Investors can defer paying taxes on earnings if they invest them in an OF. This works much like a 1031 exchange, but it doesn’t have to be a similar type of exchange, which means you could liquidate other investments, like stocks, and defer any gains on them. Tax deferral gets even better with OZ because the amount you pay on the gain goes down over time. If you invest in an OZ and hold the investment for 5 years, you will reduce your profit by 10%, which in turn reduces your taxes. For example, if you have a $50,000 gain from the sale of stock that you transfer to an OZ, after 5 years, the reportable gain you will pay taxes on is reduced by $5,000, making the taxable gain $ 45,000. If you hold the assets for 7 years, the gain is reduced by another 5%. Make the taxable gain $42,500. In 2026, you’ll need to pay taxes on the deferred capital gain, whether or not you sell the asset. However, the big benefit is when you own the property for 10 years. After 10 years, you will not pay any capital gains on the appreciation of the asset from the day you bought it. So if your investment appreciates $100,000 in 10 years and you sell it, you pay $0 in taxes.
Being forced to use OF to invest in OZ is interesting. As far as I can tell, it’s done this way to attract larger investments for the most impact, but I didn’t find anything that says you can’t set up your own OF to invest in a single property in an OZ. These benefits are great, but the way I see it, they just make it that much better. I wouldn’t specifically invest in an OZ just for the tax exemption.
Opportunity Zone Myths: Here are the two most common myths about opportunity zones that I hear:
I can convert the capital gains into OZ, keep the property for 10 years and never pay taxes on the gain.
It is true that you will never pay taxes on the capital gains of the original investment after 10 years, but you will have to pay taxes on the gains that you transferred in tax year 2026. The gains that you transferred to an OZ simply differ and will reduce over time. , but it will never be deleted.
I can buy a rental in an OZ for huge tax savings.
There are two reasons this won’t work. One of the obstacles to investing in OZ is that you need to invest through an OF. Once you identify an investment, you will need to establish 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. Pursuant to IRC Sec. 1400Z-2(d)(2)(D)(I), qualified OZ property held by a qualified OF must meet one of the following requirements:
The original use of the qualified opportunity zone property begins 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 buy a property you will need to build a new one (new original use) or make major improvements. Recently there was clarity on the definition of “substantially improved”.
To qualify for substantial improvements, you must make improvements that double your basis (make improvements equal to the amount paid for the asset) in any 30-month period while the asset is owned. The base subtracts the value of the land, so the improvements must 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. To qualify for the tax incentive, you’ll need to invest another $80,000 in the property within a 30-month period sometime in the next 10 years before you can sell the asset.
So what is the strategy?
The obvious strategy is to buy land in OZ and build to hold. Other strategies for real estate investors could be to buy and scrape to build townhomes or condominiums. In those cases, you’ll want to keep some of the units as rentals for at least 10 years. Another option that I can see some creative investors taking advantage of is accessory building units (ADUs). These are small buildings or additions that are used as additional units or apartments. These are becoming more popular with the rise of Airbnb in many areas, you don’t need to be zoned for multi-family housing to build them. Due to regulation on short-term rentals, you may need to rent them as long-term rentals, but the number might still work. I can see if you buy a single family home that needs repair, by the time you rehab the house and build an ADU, you might qualify for the tax incentive.
To see a map of OZs in your area, you can visit the US Treasury Bonds site here.