Investing in Opportunity (Zones): A Tax-Saving Strategy

by | BiggerPockets.com

Within the hundreds of pages of the latest tax reform legislation, one of the least publicized—yet most powerful—tax benefits that came out was the Opportunity Zones program.

This government program offers three powerful tax advantages to real estate investors:

  1. The ability to defer capital gains taxes on the sale of real estate
  2. The ability to permanently eliminate part of the capital gains taxes
  3. The potential ability to receive permanent tax-free gain on 10-years of forced appreciation

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The Purpose of Opportunity Zones

The Opportunity Zones (also called O-Zone) program was enacted to help improve certain distressed communities. The government’s goal was to provide tax incentives to bring in private investments in housing and other sections to revitalize these areas. Areas designated as Opportunity Zones can be found throughout all 50 states.

What Are the Tax Benefits of Investing in Opportunity Zones?

1) The ability to defer capital gains taxes on the sale of real estate.

Let’s look at an example. Jim, a resident of Florida, bought a rental for $100K at the end of 2016. In 2018, he sold it for $250K. For simplicity purposes, let’s assume $0 depreciation was taken.

Instead of paying capital gains taxes on his $150K gain, he invests the $150K into an Opportunity Zone Fund within 180 days of the sale. He calls it Ozone Fund, LLC.

This strategy will help him to defer capital gains taxes of $22,500 in 2018 (assuming a 15 percent capital gains rate).

2) The ability to permanently eliminate part of the capital gains taxes.

This means that not only will Jim defer the tax by not paying it in 2018, but he will also eliminate a portion of the taxes so that he never has to pay it in the future either.

Ozone Fund, LLC uses Jim’s $150K investment to purchase a duplex in Florida. Jim puts in an additional $100K to improve the building and turn it into a great cash-flowing property.

After holding the duplex via Ozone Fund, LLC for five years, Jim’s original capital gains of $150K will reduce by 10 percent (down to $135K), and he will have permanently eliminated $2,250 in taxes.

($150,000-$135,000) X 15% capital gains rate

In the future, Jim will only need to pay capital gains tax on $135K instead of the original $150K gain.

If Jim continues to hold the investment for at least another two years (a total of seven or more years), then his original capital gains of $150K will reduce by 15 percent—as opposed to 10 percent after five years (down to $127,500). Jim will have permanently avoided paying $3,375 in taxes.

($150,000-$127,500) X 15% capital gains rate

In the future, Jim would only need to pay capital gains tax on $127,500 instead of the original $150K.

3) The ability to receive permanent tax-free gain on appreciation.

Jim decides to continue holding onto the property in Ozone Fund, LLC. After a total of 10 years of ownership, Jim will also be able to receive permanent tax-free appreciation of the property.

Let’s assume that at the end of 10 years, the duplex is now worth $550K. Here is what the benefit looks like assuming $0 depreciation:

$550,000    Fair Market Value at the End of Year 10

$127,500     Tax Basis After Gain Recognized 12/31/26
$100,000    Improvements Made
$227,500     Total Cost Basis

$322,500     Tax-Free Gain (FMV – Cost Basis)
15%     Capital Gains Tax Rate
 $48,375     Total Permanent Tax Savings

In Jim’s example, he will be able to save up to $48,375 of taxes permanently! In fact, if he chose to, he may be able to continue holding this property until 2047 to continue the tax-free growth.

closeup of hand using scissors to cut paper that reads taxes

How to Invest in Qualified Opportunity Zones

Now that we know how powerful this new tax benefit can be, let’s go over some of the rules on how to qualify.

Qualifying Opportunity Zone Properties

Unfortunately, simply buying a property that is within one of the IRS-designated Opportunity Zones will not automatically qualify you for these wonderful tax benefits. Since the goal of the program is to improve distressed communities, additional conditions must be met. 

These requirements include:

  • The property must be purchased after 2017. 
  • Substantial improvements must be made to the property within a 30-month period. In real estate terms, this means that the owner must spend an amount at least equal to the purchase price of the building. For example, Jim purchased the Opportunity Zone duplex for $150K. For this property, $50K of the purchase price was allocated to land and $100K was allocated to the building. Jim will need to put in at least $100K of improvements within a 30-month period in order to meet the substantial improvement requirement.
  • The property must be held by a Qualified Opportunity Fund.

Forming a Qualified Opportunity Fund

Investors must first reinvest capital gains into a Qualified Opportunity Fund (QOF). The fund will serve as the investment vehicle to purchase property within a Qualified Opportunity Zone. 

A QOF must meet all of these requirements:

  • The fund must be a U.S. legal entity that files its own tax return (i.e., corporation, partnership, or multi-member LLC). This means that Jim would not have been able to simply purchase the duplex in his personal name or in a single member LLC of which he was the sole owner.
  • The legal documents of the entity must indicate that it is organized for the purpose of investing in Qualified Opportunity Zone property.
  • The fund must hold at least 90 percent of its assets in Qualified Opportunity Zone property. As such, we recommend using a new entity to act as a QOF and not using an existing entity that holds other non-Opportunity Zone properties.  
  • The self-certification must be made by the fund each year by filing Form 8996 with its federal income tax return by the return’s due date. This means that you will not have a qualified fund if the tax return is filed late. The self-certification should also indicate the first month in the initial tax year that the QOF begins.

Keep in mind that Opportunity Zone tax benefits are not limited only to the sale of rental real estate. The program can help to defer taxes on all sorts of capital gains income. Some examples can include gains from the sale of stocks, partnership interests, business interests, and even primary homes.

person on laptop searching real estate listings

Reinvesting Capital Gains

Here’s another important detail to note: you only need to reinvest the capital gains portion of a property’s sale—unlike a 1031 exchange, where you must reinvest the entire sales proceeds.

So, in Jim’s example, he could have chosen to reinvest any portion of his $150K. If he were to do a 1031 exchange, Jim would have been required to reinvest the entire amount of the property sale, which was $250K.

Similar to a 1031 exchange, however, the IRS does require the money to be reinvested within 180 days of the sale. (There are unique instances when the taxpayer may have longer than 180 days though.)

Other benefits of the Opportunity Zone program that make it better than a 1031 exchange include:

  • the ability to choose how much to reinvest into the new deal
  • the ability to receive the tax benefit without an exchange intermediary
  • the ability to avoid the 45-day identification rule

In fact, an Opportunity Zone can be a great last-minute strategy for investors who either failed a 1031 exchange or have taxable money from a 1031 exchange transaction that they would like to defer.

Completing a Tax Election

If you have met all of the requirements above, you should be in the clear to get all these wonderful tax savings, right?

Not just yet. Yet another requirement is that an election for tax deferral must also be made by the taxpayer and attached to their tax return for the year of the gain.

Critiques of the Opportunity Zone Program

As with everything in taxes, there is often some bad that comes with the good. This new tax break is no exception.

A big pitfall of the Opportunity Zones program is the requirement to pay taxes by the earlier of the property sale date or December 31, 2026. A 1031 exchange, on the other hand, can allow you to potentially defer taxes indefinitely.

So, to reiterate, a taxpayer can only defer taxes until 2026 for an Opportunity Zone transaction. This is true even if the taxpayer decides to continue holding onto the property past the 2026 mark.

In Jim’s example, for instance, if he holds onto his duplex, he would need to pay taxes on his $127,500 of deferred gain on his 2026 tax return ($150,000 minus his 15 percent adjustment for holding it more than seven years).

Summary of the O-Zone Program

As you can see, the Opportunity Zones program provides for some extremely powerful tax-saving opportunities. However, there are many hurdles to overcome and requirements that must be met in order to qualify for these tax breaks.

Unless you are a savvy investor who has a good amount of experience dealing with large improvement projects, you may be better off passively investing in someone else’s Qualified Opportunity Fund. In fact, many syndications currently exist where you can be a passive private equity investor in large funds.

The upside is that you’d receive these tax advantages without having to do all the work. Keep in mind, though, that just about anyone can create a fund. Therefore, it’s important to carefully analyze these types of passive investments. Ensure that the fund and its operators are reputable and that it does indeed meet all the IRS requirements.

If you are considering a sale transaction that may result in a large tax gain, speak with your tax advisor to determine whether the Opportunity Zones program could be a good opportunity for you.

Do you plan to invest in Opportunity Zones? Do you already have experience doing so? 

Share below. 

About Author

Amanda Han

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 years with a focus on long-term hold residential and multi-family assets across multiple states. Formerly a tax advisor at the prestigious accounting firm Deloitte in the Lead Tax Group, focusing on tax strategies for the real estate industry and high net worth individuals, and at an international Fortune 500 Company in the high-tech industry in the Corporate Tax department, Amanda’s goal is to help investors with strategies designed to supercharge their wealth building. Amanda’s highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s best seller list. A frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies, Amanda has been featured in prominent publications including Money Magazine, Realtor.com, and AllBusiness.com. Amanda was a speaker at Talks at Google and is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine. She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.

24 Comments

  1. James Gorman IV

    Good article. Mixing the opportunities of IRS 721, 1031 and 1033 Exchanges with Opportunity Zone deals & programs in Washington State sure looks to be a great concept.

    Your closing section “Summary of O-Zone Program” – was a great heads-up piece of advice.

  2. Mark Knowlden

    Appreciate this article Amanda …… great OZ overview. With the growing interest by investors and developers, I’m sure your expertise will be in high demand. This is a program that offers unique potential for financial gain, as well as positive community impact. So we are excited about moving forward with direct O-Funds to develop mixed-use, and public/private projects in targeted zones (mostly in the Pacific Northwest).

    Please continue to provide your input on this type of forum. There will be an expanding need for professional legal and accounting advice as this program develops. Thank you.

  3. Esther Torres

    Does anyone know if this can be used in Puerto Rico inconjuction with Act 20 & Act 22 and how it would work. I am a real estate broker and specialize in REO sales in Puerto Rico There are many great investment opportunities in Opportunity Zone areas located throughout Puerto Rico which could greatly benefit my clients using this strategy. Please call me at 787 631-8616. I would really appreciate this information. Thanks for the input. Great article!

  4. Greg Groves

    Thanks for the info Amanda! Is possible to mix sources of money on these transactions? For example, let’s say I had $100,000 of capital gains to defer from the sale of stock. Can I mix that with another $100,000 for a purchase or for the rehab? Also, can I use it as a down payment if I am using bank financing or do these need to be all cash transactions?

    Along those same lines, if I could I refinance out any of the money as long as I leave $100,000 of equity in the property (equivalent to the $100,000 of capital gains I am trying to defer)?

    • Amanda Han

      Thanks for your question Greg. Yes you can combine capital gains and additional cash to invest in OZone assets. Keep in mind that there is a complicated calculation at the end of the transaction on how much receives the tax-deferral and tax-free treatment. =)

    • Amanda Han

      Thanks for your question Deren. Flip profit is generally taxes as ordinary income so if your flip is ordinary income then it is not eligible for OZone. Alternative if the flip was done strategically as a capital gains transaction due to its underlying facts, then it can be eligible for OZone. The key is determine whether you are doing a flip or selling a property for capital gains.

    • Robin Webber

      Taxes being the only reason sounds good enough to me. I want to get out of the rental business (6 single family houses that have all appreciated substantially), but I don’t want a huge cap gains tax hit, especially all in the same year. This sounds perfect for me and other than the obvious risks and fees, I don’t see a downside. Perhaps a 1031 exchange into the Op fund will defer taxes beyond 2026? Not sure about that.

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