Opportunity Zones and Opportunity Zones Map
The tax overhaul bill that was passed in late 2017 garnered a great deal of attention for its changes to the tax treatment of real estate, along with other asset classes. What got less attention (at least initially) was the bill’s Investing in Opportunity Act, which established the new Opportunity Zone program, consisting of Opportunity Zones and Opportunity Funds.
The Opportunity Zone program was created to revitalize economically distressed communities using private investments rather than taxpayer dollars. To stimulate private participation in the Opportunity Zone program, taxpayers who invest in Qualified Opportunity Zones are eligible to benefit from capital gains tax incentivesavailable exclusively through the program.
Due to the relative newness of the Opportunity Zone program, Opportunity Zones are understandably unfamiliar to most investors and residents of these newly designated areas. In this article, we explain the fundamentals of the Opportunity Zone program, and the implications of Opportunity Zones for both residents and investors.
First things first, what are Opportunity Zones?
What are Opportunity Zones?
Opportunity Zones are census tracts generally composed of economically distressed communities that qualify for the Opportunity Zone program, according to criteria outlined in 2017’s Tax Cuts and Jobs Act. Since the passage of the law, Opportunity Zones have been designated in all 50 states in the US, the District of Columbia, and five US possessions (American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and the Virgin Islands). In fact, all of Puerto Rico falls into an Opportunity Zone.
Up to 25% of low-income neighborhoods that meet the income qualifications of the program (and up to 5% of non-low income tracts that meet other income and geographic requirements) in each state, district, or territory can be designated as Opportunity Zones. In states, territories, and districts with fewer than 100 census tracts, up to 25 census tracts can be designated as Opportunity Zones. Areas certified as Opportunity Zones retain their designation for ten years. More than 8,700 Qualified Opportunity Zones have already been qualified in the US and US territories.
To receive access to capital gain tax incentives, investors can invest in Qualified Opportunity Zones through Opportunity Funds.
How are Opportunity Zones Created?
Opportunity Zones are created through a nomination and designation process. Following the passage of the new tax reform, governors of US states and territories — as well as the mayor of Washington, DC — were given until April 2018 to nominate qualifying census tracts in their jurisdictions for Opportunity Zone designation. Because the Opportunity Zone program is intended to develop economically depressed areas, there are restrictions on which census tracts can qualify for designation. To qualify for nomination as an Opportunity Zone, a census tract must meet the following low-income requirements as defined by US Internal Revenue Code Section 45D(e):
- A poverty rate of at least 20%; or
- A median family income of:
- No more than 80% of the statewide median family income for census tracts within non-metropolitan areas.
- No more than 80% of the greater statewide median family income or the overall metropolitan median family income for census tracts within metropolitan areas.
Up to 25% of the census tracts of each jurisdiction that met this criterion could be nominated. An additional 5% of each jurisdiction could qualify if they met a different set of income and geographic qualifications:
- A census tract that’s contiguous with a low-income Opportunity Zone; and
- A median family income of no more 125% of the median family income of the adjacent Qualified Opportunity Zone.
Under this scope, 57% of all neighborhoods in America were up for consideration as Opportunity Zones, according to the Brookings Institute. The US Treasury assessed each nominated census tract and certified those that met the program criteria. The US Department of Treasury officially certified more than 8,700 tracts as Opportunity Zones in June 2018, constituting roughly 12% of all census tracts in the US.
A Look Behind the Opportunity Zone Program
The Opportunity Zone program was created through the Investing in Opportunity Act, which was nestled into the Tax Cuts and Jobs Act. In bipartisan support of the program, more than 100 legislators sponsored the bill across both houses of Congress. It has also been heavily championed by Senators Tim Scott and Cory Booker, the two Senators who introduced the Investing in Opportunity Act to the Senate, and Sean Parker, the ex-Napster entrepreneur who founded the Economic Innovation Group, an independent think tank that helped create the framework of the program.
The passage of the bill established two new Internal Revenue Code (IRC) sections, which outline the Opportunity Zone program: IRC sections 1400Z-1 and 1400Z-2. IRC section 1400Z-1 governs Opportunity Zones and IRC section 1400Z-2 governs Opportunity Funds.
Why Was the Opportunity Zone Program Created?
The Opportunity Zone program was created to stimulate private investment in Opportunity Zone communities in exchange for capital gain tax incentives. Instead of dedicating taxpayer money to developing thousands of low-income census tracts across the US, this program aims to stimulate the investment of the estimated $6.1 trillion of unrealized private gains held by US households. In exchange for investing in communities within Qualified Opportunity Zones, investors can access capital gains tax incentives both immediately and over the long term.
Unlike existing programs designed to encourage private investment in low-income areas through tax advantages, the Opportunity Zone program is less restrictive, less costly, and less reliant upon government agencies to function. Existing programs, such as the New Markets Tax Credit (NMTC) Program and Low Income Housing Tax Credit (LIHTC) Program, are more limited in supply and subject to annual Congressional approval and/or tax credit allocation authority. Because the tax credit system limits the number of credits issued each year, it inherently limits the number of investors who can participate, and therefore the amount of money that can be invested into the development of a community under the program.
Opportunity Zones don’t operate through a tax credit program. Instead, Opportunity Zone designation and investment are governed through two Internal Revenue Code sections. This removes any limitation on the number of Opportunity Funds that can exist, making them more the product of an entirely new IRS rule that changes the tax treatment of capital gains than the subject of a more traditionally structured tax credit program.
Unlike existing programs designed to stimulate private investment in low-income communities, Opportunity Funds can self-certify without the need for approval from the US Treasury Department. 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.
Most importantly, there is no cap on the amount of capital that can be invested into qualified Opportunity Zones through the program, and hence no arbitrary limit on the extent to which the program may help reshape downtrodden communities.
How Investing in Opportunity Zones Works
The designation of Opportunity Zones is designed to help spur the development of identified communities. In exchange for investing in Opportunity Zones, investors can access capital gains tax incentives available exclusively through the Opportunity Zone program. To access these tax benefits, investors must invest in Opportunity Zones specifically through Opportunity Funds. A qualified Opportunity Fund is a US partnership or corporation that intends to invest at least 90% of its holdings in one or more qualified Opportunity Zones.
As previously mentioned, Opportunity Funds are governed by IRC section 1400Z-2 and Opportunity Funds can self-certify to the IRS. But each Opportunity Fund is responsible for ensuring that they abide by the guidelines of the Opportunity Program in order to be able to offer tax incentives.
Because the Opportunity Zone program is intended to stimulate positive growth within designated communities, there are restrictions on the types of investments in which an Opportunity Fund can invest. These investments are called “Qualified Opportunity Zone property,” which is defined as any one of the following:
- Partnership interests in businesses that operate in a qualified Opportunity Zone.
- Stock ownership in businesses that conduct most or all of their operations within a qualified Opportunity Zone.
- Property such as real estate located within a qualified Opportunity Zone.
There are rules that govern each of these three investment options, but the rules for businesses are similar to those of the Enterprise Zone Business requirements. For property such as real estate, the rules are somewhat different. The types of real estate investments allowed by the program are limited to ensure that the communities are improved with each investment.
Essentially, Opportunity Funds can only invest in the construction of new buildings and the substantial improvement of existing unused buildings. If an Opportunity Fund invests in the improvement of an existing building, it must invest more in the improvement of the building than it paid to buy the building. Whether the building is constructed from the ground up or improved, the development of the building must be completed within 30 months of purchase.
Tax Advantages of Investing in Opportunity Zones
In exchange for following the rules of the Opportunity Zone program and investing in Qualified Opportunity Zones through Qualified Opportunity Funds, investors can receive substantial capital gain tax incentivesimmediately and over the long term.
When an investor divests an appreciated asset, such as stocks or real estate, they realize a capital gain, which is a taxable event. Under the Opportunity Zone Program, if an investor reinvests a capital gain into an Opportunity Fund, they can defer and reduce their tax liability on that gain. Beyond that, they can also potentially receive tax-free treatment for all future appreciation earned through the fund. Together, these tax incentives can boost after-tax returns for Opportunity Fund investors:
- Those who invest realized capital gains into a Qualified Opportunity Fund can defer paying capital gains tax for those earnings until April 2027 for investments held through December 31, 2026. Gains must be invested in a Qualified Opportunity Fund within 180 days in order to qualify for any tax treatment available under the Opportunity Fund program.
- Those who hold their Opportunity Fund investments for at least five years prior to December 31, 2026, can reduce their liability on the deferred capital gain principal invested in the Opportunity Fund by 10%. If the investment is held for a minimum of seven years prior to December 31, 2026, the tax liability can be reduced by 15% total.
- Those who hold their Opportunity Fund investment for at least 10 years can expect to pay no capital gains taxes on any appreciation in their Opportunity Fund investment. That’s because Opportunity Fund gains earned from Opportunity Zone investments can qualify for permanent exclusion from the capital gains tax if the investment if held for at least 10 years.
As you can see, there is a timetable that investors must follow in order to maximize the tax advantages available through the Opportunity Zone program. For those who invest in 2019, there are important milestones between 2024 to 2029.
The innovations of the Opportunity Zones program offer substantial potential to help lift economically distressed communities in pinpointed ways using a market-based approach. Investors have the power not only to transform thousands of census tracts across the US, they also can access numerous capital gains tax incentives if they stay within the guidelines of the Opportunity Zone program.