Everything You Need to Know About Qualified Opportunity Zones

January 8, 2024

Qualified opportunity zones are low-income communities in need of investment and revitalization. Created by the Tax Cuts and Jobs Act of 2017, opportunity zones give investors the opportunity to invest in economically distressed areas, doing good, while gaining a tax advantage from the federal government in the process. Keep reading for an overview of what you need to know about qualified opportunity zones.

What are qualified opportunity zones and how are they created?

According to the Economic Innovation Group, opportunity zones (OZ) are low-income census tracts nominated by governors and certified by the U.S. Department of the Treasury into which investors can make qualifying investments into new projects and enterprises in exchange for certain federal tax advantages.

Opportunity zones are an economic development tool to finance opportunities in struggling parts of the country left behind by uneven economic growth. The United States currently has more than 8,700 opportunity zones throughout the states and territories.

In order to create opportunity zones, state governors nominate a limited number of eligible tracts for official designation. The Secretary of the Treasury oversees the certification and designation of new opportunity zones. You can find more information about the eligibility criteria for census tracts and the nomination and designation process on the IRS website.

What are opportunity funds and how do they work?

If you are interested in investing in an opportunity zone, then you would do so via a qualified opportunity fund (QOF). A QOF is an investment vehicle, such as a corporation or a partnership, that exists for the purpose of investing within qualified opportunity zones. As a rule, QOFs must invest at least 90% of their assets into qualified opportunity zones in order to be eligible for federal tax benefits.

U.S. investors currently hold trillions of dollars in unrealized capital gains in stocks and mutual funds alone. By creating qualified opportunity zones and incentivizing the investment of capital gains into the revitalization of these areas through tax advantages, the federal government hopes to see lasting improvements made in communities who have been impacted by economic distress for decades. Investments into qualified opportunity funds facilitate improvements to real estate and businesses within the opportunity zones they serve.

What tax advantages are afforded to investors in qualified opportunity zones?

When you sell an asset such as a business or real estate, you incur a capital gains tax liability. However, you can roll over the capital gains into a qualified opportunity fund, thereby deferring and reducing your capital gains liability, as well as diversifying your portfolio and making a positive impact. There are two specific tax benefits afforded by the IRS when you invest in a qualified opportunity fund:

  1. You can defer the payment of capital gains tax on your original investment until the 2026 tax year, meaning you won’t actually pay the capital gains tax until you file your 2026 tax return in 2027.
  2. When you invest in qualified opportunity funds, you will obtain a greater tax benefit the longer you hold onto your investment:
    • If you keep your investment for more than 5 years, then your cost basis increases by 10%. This means you don’t have to pay taxes on 10% of your realized capital gain.
    • If you keep your investment for more than 7 years, then your cost basis increases by an additional 5%, making your capital gains tax exclusion 15%.
    • Finally, if you keep your investment for more than 10 years, then you will owe no capital gains tax on any additional appreciation beyond what you pay in 2027.

To put the capital gains tax savings into perspective, think of the net benefit to investors as being as much as 50% higher in after-tax returns than non-opportunity fund investments.

As with all tax incentives offered by the U.S. government, qualified opportunity zone tax breaks come with a number of rules and regulations.

Rules and regulations

Here are just a few of the rules that apply to investments in qualified opportunity funds:

  • Eligible capital gains must be invested into a qualified opportunity fund within 180 days from when the gain would be recognized
  • Only capital gains or qualified 1231 gains recognized for federal income tax purposes before January 1, 2027 count
  • Eligible gains cannot be generated by transactions with a relative

Many more rules and regulations apply to the investment of capital gains in a qualified opportunity fund, so we recommend reaching out to a tax professional before you consider this kind of investment.

The experts at Honest Buck are here to help you optimize a tax strategy for your childcare business. Get in touch with our team of professional accountants to see whether investing in qualified opportunity zones is the right financial move for you.

Contact us today.

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