The Story of Opportunity Zones – What are they?
Opportunity Zones are newly appointed census tracts consisting of economically underdeveloped communities that qualify for designation as outlined in the Tax Cuts and Jobs Act of 2017. Since this law was passed, Opportunity Zones were designated throughout the 50 US states, the District of Columbia, and the five US possessions (Northern Mariana, Guam, Puerto Rico, American Samoa, and the Virgin Islands). In fact, all of Puerto Rico falls into an Opportunity Zone.
Up to 25% of the low-income neighborhoods were able to meet the income qualifications of the program (along with up to 5% of non-low income tracts which met other income and geographic requirements) in each district, state, or territory. In the regions with fewer than 100 census tracts, 25 or fewer tracts were designated as Opportunity Zones. Over 8,700 Opportunity Zones were qualified in the US and US Territories. Any area certified as an Opportunity Zone will retain designation for at least 10 years.
How Were Opportunity Zones Nominated?
Opportunity Zones were chosen through a “nomination and designation” process. After the passing of the 2017 Tax Cuts and Jobs Act, the governors of US States and Territories (and the mayor of Washington, DC) were asked to nominate qualifying census tracts in their jurisdiction for Opportunity Zone designation. Since the program was intended to develop economically underserved areas, certain restrictions were applied defining which census tracts were eligible to qualify. Census tracts were required to meet the following low-income prerequisites as defined by the US Internal Revenue Code Section 45D(E):
- A poverty rate of 20% or more
A median family income of –
- Not more than 80% of statewide median family income set for census tracts within the non-metropolitan areas.
- Less than 80% of greater statewide median family income or overall metropolitan median family income within metropolitan areas.
During appointment, up to 25% of all the census tracts in every jurisdiction that met these criteria were eligible for nomination, along with an additional 5% in each jurisdiction if they met a different set of geographic and income qualifications:
- A median family income of not over 125% of the family income (median) of the adjacent Qualified Opportunity Zone.
- A census tracking which is contiguous with a low-income Opportunity Zone.
Over 57% of all the neighborhoods in America were considered for Opportunity Zone designation. The US Treasury assessed each and every nominated census tract and certified only those which met their legislation’s final criteria. Then, in June 2018, the US Department of Treasury certified over 8,700 Opportunity Zones, constituting almost 12% of all the census tracts in the US.
Why Were These Opportunity Zones Created?
Opportunity Funds and Opportunity Zones were created to stimulate private investment in underserved communities. Instead of dedicating the taxpayer’s money to develop hundreds or thousands of low-income census tracts throughout the US through traditional stimulus programs, the Opportunity Zone legislation aimed to stimulate the investment of an estimated $6.1 trillion unrealized private gains held by US households via capital gain tax incentives.
In exchange for investing in Qualified Opportunity Funds (QOFs) which then inject the investments into Qualified Opportunity Zones (QOZs), investors can access two major capital gain tax benefits that occur immediately and over the long-term.
What are the Tax Advantages that come with Investment in Opportunity Zones?
When an investor divests an appreciated asset (such as real estate, stocks, cars, artwork, etc.) they realize a capital gain. Normally, this is a taxable event. However, with the Opportunity Zone Program, if the investor reinvests a qualifying gain into an Opportunity Fund, they are eligible to defer and reduce their tax liability on that gain.
Anyone who invests the realized capital gains into Qualified Opportunity Funds is able to defer paying capital tax gains for those earnings until April 2027. At that point, their 15% total step-up in basis reduces their capital gain tax liability to 85% of its initial value. This is a substantial savings.
While this deferment and reduction is a powerful tax incentive, this benefit pales in comparison to the magnitude of the second. Far more significant, if an investor keeps their capital gain invested in an Opportunity Fund for at least 10 years, that investment is eligible to receive federal tax-free treatment. In other words, any future appreciation earned through investing in an Opportunity Fund pays zero federal capital gain taxes. What an incredible tax benefit!
Together, these two incentives: the (1) deferment and reduction and the (2) capital gain tax elimination can boost after-tax returns for Opportunity Fund investors.
Note: All the gains need to be invested in a Qualified Opportunity Fund within a time period of 180 days in order to qualify for the tax treatment available under Opportunity Funds. Learn more about the tax advantages of Opportunity Funds.
How is the Opportunity Zone Program different?
Unlike other stimulus programs designed to encourage private investments in low-income areas, Opportunity Zones offer restrictive, less costly, and lesser reliance on government agencies to function. Tax credit programs like the Low Income Housing Tax Credit (LIHTC) Program and New Markets Tax Credit (NMTC) Program were critically evaluated for their limited supply and subjection to annual Congressional approval and/or credit allocation authority that limit their scope and effect.These tax credit systems are known to limit the number of credit issued every year, which inherently restricts the number of investors that can participate and the money that can be invested to the benefit of the communities and investors under the program.
In contrast, Opportunity Zones do not operate through a tax credit program. Instead, the Opportunity Zone Program is defined and governed by two Internal Revenue Code Sections. This design allows for unlimited capital gain investors and investments in the Qualified Opportunity Zones, freeing the program to operate within the free market and induce positive investment impact as deemed profitable by investors. This is a new way to stimulate growth in underserved areas, and one that has the potential to produce considerable improvements in the United States.
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