By Blake Christian, CPA, MBT and Hank Berkowitz, MBA, MA
From the March/April 2023 Issue
Since 2017, the federal Opportunity Zone (OZ) program has allowed investors to defer short-term and long-term capital gain income (until 2026) that they’ve generated from all asset classes including business sales—not just real estate. They do so by reinvesting their gains into a business or property located in one of over 8,700 designated low-income census tracts. What’s more, the appreciated value in a qualified opportunity fund (QOF) investment is 100% tax-free if held for 10 years or more, and if all IRS rules are followed.
Bipartisan legislation is pending to extend the original gain deferral period for another two years (to December 31, 2028). The legislation would also reinstate the 5% and 10% basis adjustment benefits that sunsetted at the end of 2021. It would further allow a newly defined “fund of funds” investment structure.
As we explained in a recent HUD/Cityscape report, early data shows that the OZ program has had a positive impact—albeit modest—on both employment and property values within OZ census tracts.
Starting Or Relocating A Business To An Opportunity Zone
Altruism aside, there are certain advantages to moving your business into an OZ census tract if you are acquiring real estate or operating assets in that zone, or if you are acquiring another business located in that zone, or seeking investment. The cost of capital is generally lower than it would be outside of an OZ, since there are many government incentives for investors.
For an entity to qualify as a qualified opportunity zone business (QOZB) it must meet one of the following criteria:
- The management, operations, and tangible property needed to generate 50% or more of the gross income of the business must be located within one or more Opportunity Zones; or
- At least 50% of the services performed for the business by employees and independent contractors (based on either hours worked or compensation paid) are performed in one or more Opportunity Zones.
Investors have taken notice. According to data from Novogradac, Qualified Opportunity Funds had raised over $34 billion in equity as of December 31, 2022—a record $9.68 billion of that in 2022 alone. When adding in non-public OZ Funds and the debt component of capital raised, the amount of investment committed to the program is likely four to five times higher.
Update On Legislation
The Opportunity Zones Transparency, Extension and Improvement Act was introduced in April of 2022 in both the Senate and the House of Representatives. In addition to extending the OZ program through 2028 from 2026, this legislation would restore the reporting requirements from the original Investing in Opportunity Act and would:
- Remove OZ designation (prospectively) from certain higher-income census tracts.
- Modify the definition of QOF to allow for feeder funds.
- Establish a State and Community Dynamism Fund.
- It is uncertain whether this legislation will move forward during the 118th Congress, but OZ insiders remain optimistic that it will pass.
Impact And Benefits
OZ investments have funded hundreds of housing projects (affordable, attainable, and market-rate projects), clean energy projects, biotechnology and medical infrastructure projects, active businesses, solar energy projects, and many successful public-private infrastructure partnerships.
OZ projects have become a very attractive alternative investment sector for high net worth individuals and institutional investors. Even with a 10-year investment horizon, private equity and venture capital firms have started making OZ investments. Many developers and other real estate investors have found the OZ structure preferable to IRC 1031 exchanges since the OZ structure offers a much longer replacement period. This allows taxpayers who set up their own “captive” QOF a minimum of 37 months from their gain event to reinvest the gain.
With proper planning, that reinvestment period can be extended to as long as 55 months. Holding the OZ Fund the requisite 10-year period also eliminates depreciation recapture, a costly annoyance upon exiting traditional real estate deals. This lack of recapture typically adds another 2.5% or more per year (25% over 10 years) in IRR to OZ projects over non-OZ projects.
With a slowing economy and mid- to long-term inflation, OZ investing is even more attractive. Interest rates spikes have resulted in a flood of bargain purchases of raw land, residential, and commercial properties these days. The generous reinvestment timelines under the OZ program allow for more patient development and capital improvement. For savvy OZ investors the likely appreciation over the next decade will be 100% tax-free at the federal, and tax-free at the state level in all but five states.
Christian, CPA, MBT, is a tax partner in the Park City, UT, office of HCVT: Holthouse Carlin & Van Trigt LLP. Berkowitz, MBA, MA, is a financial journalist and analyst based in Norwalk, CT.