What Are Opportunity Zones and How Do They Work?

One disadvantage of buying real estate is that, when you go to sell it, you have to pay capital gains tax on any profit you make through the sale. Because investment properties don't qualify for a homeowner exclusion—you can only adjust the cost basis—capital gains tax can really eat into real estate investors’ profit and limit the funds they have to build their portfolios.¹

Fortunately, savvy real estate investors have some options available to defer paying the IRS and reduce their tax burden.

One of those ways is to engage in a "like-kind," or 1031, exchange. This section of the tax code allows you to trade one real property for another of equal or greater value without paying capital gains tax on the sale of the first property.² As long as you don't liquidate your real estate holdings, you can continue trading up the property ladder while avoiding taxation until you finally go to sell the asset.

Qualified Opportunity Zones (QOZ) work like 1031 exchanges in that both allow you to defer your tax burden. However, Opportunity Zones are even more advantageous to real estate investors because they also yield substantial tax breaks to individuals who are willing to hold the property for at least a decade.

Read on to learn more about economic Opportunity Zones and how you can take advantage of the tax breaks that come with them.

The Opportunity Zones tax incentive, part of the Tax Cuts and Jobs Act, rewards investors who are willing to contribute to the economic growth and development of distressed areas across the United States by purchasing real property or equity shares in local businesses. It provides a way of putting private investment funds to work, in communities that lack resources, with the hope of creating economic equity.

Here's how it works.

To invest in an Opportunity Zone, you (the real estate investor) first must sell an asset that generates capital gains. Instead of paying the capital gains tax, you file a Form 8896 with the IRS and create a Qualified Opportunity Fund (QOF). A QOF takes the form of either a corporation or a partnership and is required by federal law to place at least 90 percent of its holdings into an Opportunity Zone.

In 2017, 8,764 low-income and contingent regions in the 50 states, the District of Columbia, and the five U.S. territories became Qualified Opportunity Zones (QOZs) after being nominated and certified by the U.S. Treasury.³

There are two types of tax benefits you'll receive when investing in a QOZ.

You will not have to pay capital gains tax on properties purchased in a QOZ until something happens to reduce or terminate the qualifying investment—for example, you go to sell it.

The second benefit is a considerable tax break on the profits from your QOF investment, which is achieved by incremental increases in the cost basis of any property held by a QOF. This tax benefit increases the longer you hold the investment, as follows: ⁴

• If you hold the QOF investment for five years or more, the basis of the QOF investment increases to 10 percent of the deferred gain
• If you hold the investment for at least seven years, the basis of the QOF investment increases to 15 percent of the deferred gain
• If you hold the investment for at least 10 years, you may elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged

Suppose you invested in a QOF valued at $100,000 in 2022. By 2032, that property would be worth $500,000. If you were to sell it under normal circumstances, you'd owe capital gains tax on the entire profit, minus any adjustment to the cost basis due to improvements you made to it during the time you owned it. Thus, you could end up paying capital gains tax on as much as $400,000.

However, if you purchased the same property through a QOF, you would be able to re-adjust the cost basis to reflect the fair market value on the sale date. That means you could value the property at $500,000. As a result, you would owe no capital gains tax whatsoever.

There are a few rules you’ll need to know when investing in a Qualified Opportunity Zone.

1. You have 180 days from the sale or 1031 exchange of a property that has appreciated capital gains to invest those gains in a Qualified Opportunity Fund.
2. Once the realized gains are in the QOF, the funds then must be used to purchase property in one or more Qualified Opportunity Zones.
3. Only the appreciation from capital gains is eligible for tax-deferred status, but unlike a 1031 exchange, there is no “like-kind” requirement, and you can invest any capital gains appreciation, including appreciation from the sale of stock, into a QOF.⁵
4. The holdings in Qualified Opportunity Funds were designed to spur new growth in Qualified Opportunity Zones. Thus, the property already in use will not qualify unless substantial improvements are made to it. You have 30 months to sink more than the purchase price into the investment.
5. Some businesses—golf courses, racetracks, gambling facilities, country clubs, and so on—do not qualify as QOF investments.

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