What Are Opportunity Zones in Commercial Real Estate?

Opportunity Zones offer a unique way for commercial real estate investors to boost development in low-income neighborhoods while benefiting from tax breaks. 

Read on to learn more about Opportunity Zones, their tax benefits, and how to get involved. 

What Is an Opportunity Zone?

An Opportunity Zone is an economically distressed community nominated by a state governor and certified by the U.S. Treasury and Internal Revenue Service (IRS). 

The designation of Opportunity Zones started with the 2017 Tax Cuts and Jobs Act. The Qualified Opportunity Zone (QOZ) program was designed to encourage economic growth in underserved communities through tax incentives to investors and is set to end in 2047.

To qualify as an Opportunity Zone, the area must have a minimum poverty rate of 20% and a median income of no more than 80% of the statewide median family income.

To date, there are 8,764 Opportunity Zones nationwide.

What are Opportunity Funds?

To qualify for tax benefits, investments in Opportunity Zones must be made via an Opportunity Fund—a partnership or corporation designed to invest in QOZ property. 

Opportunity Funds must hold at least 90% of their assets in QOZ property, which can include stock, partnership interests, and/or real estate used in a trade or business in a QOZ. 

However, certain businesses are prohibited from Opportunity Fund investments, including liquor stores, massage parlors, gambling-related businesses, golf courses, tanning salons, and other “sin” businesses.

Since October 2018, Opportunity Funds can be self-certified with the IRS and U.S. Treasury (and certify the 90% asset requirement) via Form 8996 on federal tax returns.

Tax Benefits of Investing in Opportunity Funds

Investing in Opportunity Funds may let you defer and/or reduce your capital gains taxes. 

First, any capital gains invested into an Opportunity Fund within 180 days can be deferred up to nine years. Furthermore, any gain on those funds can qualify for a 10% tax reduction if the interest is held for five years and a 15% reduction if held for seven.

Secondly, any gains on investments made with tax-deferred funds become tax-exempt once the interest is held for 10 years. (Gains on non-tax-deferred funds don’t qualify for this benefit.) 

Source: https://opportunityzones.hud.gov/investors

Example Opportunity Fund Investment

Imagine you sell some stocks, resulting in a capital gain of $100,000. Instead of paying capital gains taxes on the sale, you invest it in an Opportunity Fund within 180 days. Furthermore, you plan to keep your funds invested for 10 years. 

Assuming the Opportunity Fund generates a 10% annualized return, your original $100,000 invested would turn into about $260,000 by the end of the hold period (10 years).

In this case, you could not only defer the capital gains tax on the original $100,000 invested but owe no tax on any gains made from the $100,000 while it was in the Opportunity Fund. In other words, you could withdraw the $160,000 profit ($260,000 – $100,000) tax-free.

Example Opportunity Zone Property Investment

As a fund manager, you can also choose which properties are held within an Opportunity Fund.

Opportunity Funds can invest in developing new properties within the Opportunity Zone or substantially improving properties already existing within the Opportunity Zone. In the latter case, the fund must invest more than the amount paid for the building back into the property. 

For example, imagine you acquire an existing property within an Opportunity Zone and $1 million of the purchase price goes toward the building. In this case, the fund has 30 months to invest an amount over $1 million into improving the property. Otherwise, the property won’t qualify for the program’s tax benefits. 

Potential Risks of Opportunity Zone Investing

Of course, Opportunity Zone investing isn’t without risk.

For one, Opportunity Funds not invested in Qualified Opportunity Zones could lose the anticipated tax benefits and face a 6% penalty.

At the property level, some Opportunity Zone projects could fail to develop as expected, distressed neighborhoods could hold property values down, and construction projects could face delays and budget overruns. 

To receive the full tax advantages, investors must also hold their investment for 10 years, a long-term commitment that can be challenging if the project underperforms or you need to liquidate.

Ultimately, developers must gauge the viability of a project on a case-by-case basis. Ideally, the numbers will pencil even without the anticipated tax benefits. 

Frequently Asked Questions (FAQs)

How do I find out if a property is in an Opportunity Zone?

Check the U.S. Department of Housing and Urban Development’s Opportunity Zone map.

What is the deadline to invest in Opportunity Zones?

The program is set to end in 2047, but to take full advantage of the tax incentives (especially the 10-year capital gains exemption), investments should be made sooner than later. The current deadline for deferring capital gains is December 31, 2026.

What happens if I sell my investment before 10 years?

If you sell your investment before 10 years, you may still benefit from deferred capital gains, but you will not qualify for the full tax exemption on the Opportunity Fund’s earnings.