IRC 1400Z-2: Tax Rules for Opportunity Zone Investing

Internal Revenue Code Section 1400Z-2 established the Opportunity Zone program, a tax incentive created to foster long-term investment in designated low-income communities. The program offers tax advantages to investors who redirect capital gains into these areas. The goal is to stimulate economic development and job creation by connecting private capital with underfunded communities.

Core Tax Incentives

The appeal of the Opportunity Zone program lies in three tax incentives for investors who reinvest eligible capital gains into a Qualified Opportunity Fund (QOF). The first benefit is a temporary deferral of the original capital gain. An investor can postpone paying tax on this gain until they sell their QOF investment or until December 31, 2026, whichever comes first.

A second incentive involves a reduction of the deferred gain. If the QOF investment is held for at least five years, the basis is increased by 10% of the deferred gain. A 15% basis increase was also available for investments held for seven years, but the deadline to qualify for this benefit has passed.

The most significant benefit is for long-term investors. If the QOF investment is held for at least 10 years, the investor can elect to have the basis of the QOF investment adjusted to its fair market value on the date it is sold. This means any appreciation in the QOF investment is permanently excluded from capital gains tax. For instance, if a $100,000 gain is invested in a QOF and grows to $250,000 over 10 years, the investor pays tax on the original deferred gain in 2026 but owes no capital gains tax on the $150,000 of appreciation when the investment is sold.

Qualifying for Tax Deferral

To qualify, an investor must have an eligible short-term or long-term capital gain from the sale of property like stocks, real estate, or a business to an unrelated party. Only the gain portion of the sale proceeds is eligible for reinvestment and deferral, not the entire amount received.

The reinvestment is governed by a 180-day rule. An investor has 180 days from the date of the sale that generated the capital gain to invest that gain into a QOF. Missing this deadline means the opportunity to defer that specific capital gain is lost.

The start date for the 180-day period can vary for gains from pass-through entities like partnerships or S corporations. A partner can choose to start their 180-day clock on the date of the partnership’s sale, the last day of the partnership’s taxable year, or the due date of the partnership’s tax return for that year. This provides flexibility for individual tax planning.

The Qualified Opportunity Fund Investment

The vehicle for participation is a Qualified Opportunity Fund (QOF), which is a U.S. corporation or partnership organized to invest in Qualified Opportunity Zone Property. A QOF must self-certify with the IRS and meet a 90% asset test. This test requires the fund to hold at least 90% of its assets in such property and is performed twice a year.

Qualified Opportunity Zone Property (QOZP) can be stock in a Qualified Opportunity Zone Business, a partnership interest in one, or tangible property used in a trade or business. For tangible property to qualify, it must be new or “substantially improved” by the fund.

A Qualified Opportunity Zone Business (QOZB) must meet several requirements. A key rule is that at least 70% of the tangible property owned or leased by the business must be located within a Qualified Opportunity Zone. If the business acquires existing tangible property, it must substantially improve it, which means making investments that double its basis over a 30-month period.

A QOZB must also derive at least 50% of its total gross income from the active conduct of its business within the zone. Additionally, a substantial portion of its intangible property must be used in the business, and it is limited in the amount of nonqualified financial property it can hold. These rules ensure investments translate into genuine economic activity.

Making the Election and Reporting

An investor must formally elect to defer the gain on their federal tax return for the year the gain was incurred. This is done using Form 8949, “Sales and Other Dispositions of Capital Assets,” where the taxpayer reports the sale and follows specific instructions to indicate their intent to defer it under the Opportunity Zone rules.

In addition to the initial election, taxpayers must file Form 8997, “Initial and Annual Statement of Qualified Opportunity Fund Investments,” with their tax return. This form is filed for the first year and every subsequent year the QOF investment is held.

Form 8997 tracks the investor’s QOF holdings and is used to report events that might affect the investment, such as selling a portion of the interest. Failure to file this form annually can jeopardize the tax benefits, making it a compliance requirement.

Maintaining the Investment and Realizing Benefits

The deferred gain must be recognized on the earlier of the date the QOF investment is sold or December 31, 2026. When this gain is recognized, the investor’s basis in their QOF investment is increased by the amount of gain they report. This adjustment prevents the same dollars from being taxed twice upon the eventual sale of the QOF investment.

An investor must be careful to avoid an “inclusion event,” which accelerates the recognition of the deferred gain. Common inclusion events include selling the QOF investment, receiving certain property distributions from the fund, or gifting the investment. If an inclusion event occurs, the deferred gain must be reported on the tax return for that year.