Thanks to the new, unique set of tax incentives offered under the Opportunity Zone program, many investors are now wondering how to invest in Opportunity Zones themselves. In addition to considerable immediate and long-term tax advantages, Opportunity Zone investments offer wider access to tax incentives. Unlike tax credit programs of the past, Opportunity Zone investments come with significantly fewer restrictions, which opens up access to the new investment option.
Despite the benefits of Opportunity Zones, this newly created investment territory is unfamiliar to most investors. In this article, we explain the basics of the Opportunity Zones, their tax incentives, and outline ways to invest through an Opportunity Fund.
First, let’s look at what Opportunity Zones are and why they were created.
How do Opportunity Zones Work?
The Opportunity Zone program was created under the Investing in Opportunity Act, which was part of the larger Tax Cuts and Jobs Act of 2017. The act was designed to encourage private investment in economically distressed neighborhoods by offering investors access to new capital gains tax incentives in exchange for placing qualified investments in Opportunity Zone communities through a new investment vehicle called an Opportunity Fund.
Opportunity Zones were created under a nomination and certification process. State and US possession governors, as well as the mayor of Washington DC, were able to nominate up to 25% of census tracts within their jurisdictions, which met low-income requirements defined by Internal Revenue Code (IRC) section 45D(e). In states, territories, and districts with fewer than 100 census tracts, up to 25 census tracts were eligible to be nominated. Governors and the mayor of Washington DC were also able to nominate up to 5% of non-low income tracts, which met other income and geographic requirements.
Today, there are more than 8,700 Qualified Opportunity Zones in all 50 states in the US, the District of Columbia, and in five US possessions, which cover approximately 12% of all census tracts in the US. Current Opportunity Zones received their designation in 2018 will retain that designation for ten years.
How does the Opportunity Zone Program Differ from Tax Credit Programs?
Several tax credit programs intended to encourage investment in low-income areas existed before the creation of the Opportunity Zone program. Tax credit programs such as the New Markets Tax Credit Program and Low Income Housing Tax Credit Program generally rely more upon government agencies to function, and are more costly to administer. Tax credit programs are also subject to annual Congressional approval and/or tax credit allocation authority, which are limited in supply due to the nature of tax credit programs. Because the tax credit system limits the number of credits which can be issued each year, there’s an intrinsic limit on the number of investors who can participate, and the total amount of dollars that can be invested into the development of a community under these programs.
Opportunity Zones are different from these programs in a few ways. The biggest difference is that the Opportunity Zone program doesn’t operate through a tax credit program. Instead, the Opportunity Zone program is regulated by two IRC sections, which were established with the passage of the Investing in Opportunity Act. IRC sections 1400Z-1 and 1400Z-2 regulate the Opportunity Zone program and its components: 1400Z-1 governs Opportunity Zones and 1400Z-2 governs Opportunity Funds.
Because the Opportunity Zone program is regulated through IRC sections, regulations are less restrictive and burdensome for investors. There is no limit on the number of Opportunity Funds that can exist, which means that there’s no cap on the number of investors who can participate or the amount of money that can be invested through an Opportunity Fund. Also unlike existing programs, Opportunity Funds can self-certify without prior approval from a government agency. This means that Opportunity Funds are managed entirely in the private market with the administration of the funds falling solely on the shoulders of fund managers rather than government agencies or investors.
Therefore, the availability of Opportunity Funds open for investment is not artificially limited. Instead, it’s limited only by the number of Opportunity Funds offered in the private market and by the investor requirement of each individual fund.
What Tax Incentives do Opportunity Zones Offer?
In exchange for investing in Qualified Opportunity Zones according to Opportunity Zone program regulations, investors can access significant tax incentives exclusive to the Opportunity Zone program. To access these tax benefits, investors must invest in Opportunity Zones specifically through an Opportunity Fund.
When an appreciated asset is sold or otherwise divested, an investor realizes a capital gain, which is typically a taxable event. If an investor reinvests that realized capital gain into a Qualified Opportunity Fund, they can defer and reduce their tax liability on that gain. Additionally, they can also potentially realize all capital gains earned from their Opportunity Zone investment tax-free. Here’s a look at all of the capital gains tax incentives that an investor can access through an Opportunity Zone investment:
- Investors can defer capital gains taxes on earnings from many types of investments up to 2027. In order to defer tax liability until 2027, an investor must hold the Opportunity Fund investment through December 31, 2026. If the investment is sold before 2027, the capital gain moved into the Opportunity Fund investment will become taxable the year that it’s realized. By deferring tax payments, an investor can hold onto their capital longer and use it to boost earning potential to a greater degree than they would have been able to had they been liable for capital gain taxes the year that the gain was realized.
- Investors who hold an Opportunity Fund investment for at least five years prior to the end of the deferment period (December 31, 2026) can reduce taxes owed on the capital gain invested into an Opportunity Fund by 10%. If the Opportunity Fund investment is held for at least seven years prior to the end of the deferment period, the tax liability owed on this capital gain can be reduced by a total of 15%.
- Earnings from Opportunity Fund investments held for at least ten years can qualify for permanent exclusion from capital gains taxation. This means that Opportunity Fund investors can expect to pay zero capital gains taxes when they realize appreciation from their Opportunity Fund as long as they’ve held the investment for ten years or more.
This set of tax incentives available exclusively to Opportunity Zone investments offers investors a new powerful way to improve tax treatment of capital gains earned from several types of investments.
However, due to the fact that the Opportunity Zone program is intended to encourage positive growth within economically distressed communities, there are restrictions on the types of investments that an Opportunity Fund can hold.
Which Opportunity Zone Investments Qualify for an Opportunity Fund?
To qualify for tax incentives outlined above, Opportunity Zone investments must be made through a qualified Opportunity Fund. A qualified Opportunity Fund is a US partnership or corporation that intends to invest 90% or more of its holdings in “Qualified Opportunity Zone property.” Qualified Opportunity Zone property is limited to:
- Interests in a partnership that operates as a qualified business in a Qualified Opportunity Zone.
- Stock ownership of qualified businesses whose operations are based mostly or entirely within an Opportunity Zone.
- Property, such as real estate, located within an Opportunity Zone.
There are regulations governing each type of Qualified Opportunity Zone property, and the regulations governing the first two types of qualifying investments pertaining to businesses are similar to those found in the Enterprise Business Zone regulations. However, the regulations that govern the third type of investment – property – are different.
To ensure that property investments improve the neighborhoods in which they’re made, there are limitations on the types of real estate investments that qualify for inclusion as Qualified Opportunity Zone property. In general, Opportunity Funds can invest only in the construction of new buildings and the substantial improvement of existing buildings. If an Opportunity Fund invests in the improvement of an existing building, it is required to invest at least as much into the improvement of the building as it paid to buy the building. For all property investments, development of the building must be completed within 30 months of purchasing the property.
As previously mentioned, one reason why the Opportunity Zone program offers greater access and simplicity is due to the fact that Opportunity Funds can self-certify without prior approval. With that freedom, though, the responsibility of ensuring that an Opportunity Fund abides by all regulations (and therefore its investments can receive preferential tax treatment) falls on the shoulders of the fund administrators.
How to Invest in Opportunity Zones
As you can see from the previous sections, there are both time and investment constraints that investors must follow in order to access all tax incentives available to Opportunity Zone investments. Fortunately for investors, the Opportunity Zone program is designed to encourage investment both through reducing red tape for investors and through exclusive tax incentives.
Here are the steps to invest in Opportunity Zones with or without a realized capital gain:
- Invest the realized capital gain into a Qualified Opportunity Fund within 180 days of realization. No intermediary is required for this transaction. An investor can invest directly into an Opportunity Fund themselves.
- Indicate that you’ve rolled over your capital gain into Qualified Opportunity Fund when reporting income taxes to the Internal Revenue Service (IRS) through IRS Form 8949. This is required in order to be able to defer and potentially reduce capital gains taxes.
- Pay deferred capital gains taxes when they become due. If the Opportunity Fund investment is held for the maximum deferment period, which ends December 31, 2026, taxes will due in 2027. If the Opportunity is held for at least seven years prior to the end of the deferment period, taxes owed on the gain can be reduced by 15%, as described above. If the Opportunity Fund investment is sold prior to the end of the deferment period, taxes will be due the year that the gain is realized.
- Potentially pay zero capital gains taxes on returns earned from your Opportunity Zone investment. If an Opportunity Fund investment is held for at least ten years, an investor can expect their returns to be permanently excluded from capital gains taxation. If the investment is held for less than ten years, an investor can expect to miss out on tax exclusion benefits on earnings and incur a tax liability upon realizing gains.
In terms of reporting to the IRS, an investor only needs to self-report their Opportunity Fund investment on their income tax return using a single form.
In terms of property investments, unlike a 1031 Exchange, no intermediary is required to invest realized gains into an Opportunity Fund. This reduction in regulation can help speed up the investment timeline and reduce the possibility of obstacles within the 180-day reinvestment window. Additionally, the absence of an intermediary can reduce costs for investors.
Next Steps in Getting Started
Thanks to the exclusive set of capital gains tax incentives available under the Opportunity Zone program, Opportunity Funds offer long-term investors to a new way to potentially earn significantly better returns than they would following a traditional investment path. While Opportunity Funds are limited in what they can invest in, there are currently few limitations on the types of capital gains that can be invested in Opportunity Funds.
As the first real estate investment platform to create a simple, low-cost way for anyone to invest in real estate, Fundrise has a history of embracing new investment structures that offer the potential for lower fees and higher net returns for our investors. We created the Fundrise Opportunity Fund to offer investors an effortless way to access high-quality real estate properties located in the most promising Opportunity Zones with strong long-term growth potential across the US.
In Los Angeles alone, Fundrise has invested or committed approximately $100 million in neighborhoods in and along the areas now designated as Opportunity Zones. Our technology-enabled investment approach coupled with our partnerships with leading expert teams devoted to Opportunity Fund management enable us to take a nimble, and cost-effective approach to investing in Opportunity Zones nationwide.
Are you interested in what your after-tax returns could look like if you invest in an Opportunity Fund? Use the calculator below to see what your after-tax returns could be in the short-term and long-term.