The Tax Cuts and Jobs Act of December 2017 established the Opportunity Zone program as a novel investment mechanism. Its primary objective is to incentivize investors to channel funds into financially disadvantaged communities, thus encouraging economic growth in those areas. Suppose investors allocate funds into these areas, known as Qualified Opportunity Zones (QOZ). In that case, they may receive immediate and eventual tax benefits, such as the deferral of gain, partial forgiveness of deferred gain, and complete forgiveness of certain future gains, as long as specific investment requirements are met. Recently, on October 19, the Treasury Department and the Internal Revenue Service issued proposed regulations and published guidance regarding the QOZ tax incentive.
The program permits investors to defer a portion of their capital gains taxes temporarily and possibly even eliminate certain future capital gains taxes when they invest their realized gains into a Qualified Opportunity Fund (QOF). The QOF is a corporation or partnership that invests no less than 90% of its assets in Qualified Opportunity Zone (QOZ) property or interests. To be eligible for the tax benefits, investors must invest their realized gains into a QOF within 180 days of realization, which is typically the date the asset is sold. Additionally, the QOF must not simply purchase and hold the QOZ property or asset, but must also make significant improvements to the property.
- Deferral of gain. Investors who invest in a QOF can avail themselves of a deferral of their capital gains taxes invested until either December 31, 2026, or their departure from the QOF, whichever comes first.
- Partial forgiveness of deferred gain. Investors can benefit from a 10% reduction in their deferred capital gains and a corresponding 10% step-up in basis if they hold the funds in the QOF for a minimum of 5 years. Additionally, a 15% reduction in deferred gains and a 15% step-up in basis is possible after 7 years of holding the funds in the QOF.
- Forgiveness of additional gains. Should investors retain their funds in the QOF for at least 10 years, any gains earned as a result of the appreciation of the QOF will be entirely and permanently exempt from taxation.
The QOZ program differs from a 1031 exchange in multiple ways. While a 1031 exchange can solely be utilized with real estate assets, allowing investors to sell investment real estate and trade it for replacement investment real estate, the QOZ program offers tax benefits for gains from the sale of any asset, including real estate, stocks, bonds, etc., that are invested in a QOF. Additionally, under the QOZ program, the funds must be invested in the QOF, which then invests in the property. As a result, investors are unable to combine a 1031 exchange with a QOZ investment since a QOF is not considered “like-kind” to real estate and would not qualify as replacement property. Furthermore, investors cannot perform a 1031 exchange out of a QOZ investment since the QOF is invested in the property rather than the individual.
Like with any tax deferral strategy, it is advisable for investors to collaborate with their trusted advisors to ascertain the most suitable option for their specific situation.
A Comparison between the Opportunity Zone Program and IRC Section 1031 Exchange
| 1031 Exchange | Opportunity Zone Program | |
| Eligible asset classes | Only real property held for investment or business purposes | Any |
| How much needs to be invested | All proceeds for full tax deferral | Only capital gains, in any amount |
| Investment deadline | 180 days | 180 days |
| Where can you invest | Anywhere in the U.S. | Only in QOZ’s through a QOF |
| Is an intermediary required | Yes | No |
| Tax benefits |
- While perpetual exchanges allow for indefinite tax deferral, any capital gains upon the sale of the final replacement property are subject to full taxation
- In the event of the exchangor’s death, their heirs receive a stepped-up basis equal to the property’s market value.
- Deferred capital gains will remain so until December 31, 2026.
- OZF investments are eligible for a 10% increase in basis after 5 years and a 15% increase after 7 years.
- Gains from QOF investment are entirely exempt from capital gains tax after a 10-year holding period.
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