Opportunity Zones: IRS Rules and Tax Implications

The Opportunity Zone program, established by the Tax Cuts and Jobs Act of 2017, offers tax incentives to encourage long-term investments in economically distressed communities. These designated areas, known as Qualified Opportunity Zones (QOZs), exist in all 50 states, the District of Columbia, and five U.S. territories. By investing in these zones through a special investment vehicle, investors can access significant tax advantages.

Core Tax Incentives for Investors

The Opportunity Zone program’s primary attraction is its tax incentives for investors who place capital into a Qualified Opportunity Fund (QOF). The first benefit is a temporary tax deferral. An investor who realizes a capital gain from selling an asset can postpone paying federal tax on that gain by reinvesting it into a QOF. The tax payment on the original gain is deferred until the QOF investment is sold or December 31, 2026, whichever comes first.

A second, now-expired benefit was a basis step-up on the deferred gain for early participants. Investments held for five years could receive a 10% basis increase, and those held for seven years could receive a 15% increase. The deadlines to qualify for these holding periods were in 2019 and 2021, respectively.

The most significant incentive is the permanent exclusion of future gains. If an investor holds their QOF investment for at least 10 years, their basis in that investment is adjusted to its fair market value on the date of its sale. This means any appreciation in the value of the QOF investment itself becomes completely tax-free. For example, if an investor reinvests a $100,000 capital gain into a QOF and sells it for $250,000 after 11 years, the $150,000 of appreciation is not subject to federal capital gains tax.

Requirements for Deferring a Gain

To use the Opportunity Zone program, an investor must first have an eligible gain to defer. The program applies to capital gains, including those from the sale of stocks, bonds, real estate, or a business, as well as qualified Section 1231 gains. Ordinary income, such as wages, is not eligible. The gain must be recognized for federal tax purposes before January 1, 2027, and cannot come from a transaction with a related person.

An investor must reinvest an amount equal to the eligible gain into a QOF within 180 days of the sale that generated the gain. For most individuals, this period begins on the date of the sale. The rules provide more flexibility for gains from pass-through entities like partnerships or S corporations. In these cases, the partner or shareholder can choose to start their 180-day clock on the date of the entity’s sale, the last day of the entity’s tax year, or the due date of the entity’s tax return for that year, without extensions.

Investments are not made directly into a property or business but into a QOF, which is a U.S. partnership or corporation organized for investing in QOZ property. These self-certified funds must hold at least 90% of their assets in qualified opportunity zone property. The investor’s role is to make an equity investment in a fund. The IRS provides a list of designated QOZs but does not endorse specific QOFs, placing the responsibility of due diligence on the investor.

Making the Deferral Election with the IRS

After investing an eligible gain into a QOF, the investor must report the deferral election on their federal tax return. This process involves two primary IRS forms. The initial deferral is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which is filed for the tax year in which the gain was realized.

To make the election, the taxpayer reports the original transaction on Form 8949 as they normally would. A specific notation is then made on the form to adjust the gain, reducing the taxable amount for the current year by the amount reinvested. The taxpayer must also include the Employer Identification Number (EIN) of the QOF they invested in on the form.

The investor must also file Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments. This form is filed for the first time in the year the QOF investment is made and must be attached to the tax return. On the initial filing, the investor reports the new QOF investment, providing the fund’s name and EIN, the investment date, and the amount of gain deferred.

Annual Reporting and Maintaining the Investment

The program requires annual compliance. Form 8997 must be filed with the investor’s tax return every year they hold an investment in a QOF. This form serves as an annual statement that tracks the status of all QOF investments. Failure to file Form 8997 each year can trigger the recognition of the deferred gain.

If an investor disposes of their QOF interest before holding it for 10 years, it is considered an inclusion event. This event triggers the recognition of the previously deferred capital gain in the year of the sale. The amount of gain to be recognized is the lesser of the remaining deferred gain or the fair market value of the investment minus its basis, which is initially zero.

If the QOF investment is held for at least 10 years, the investor can make an election in the year of sale to receive the program’s main benefit. By electing on Form 8949 to step up the basis of the QOF investment to its fair market value, any appreciation on the investment itself becomes tax-free. Investors should also understand that the QOF itself has compliance obligations, such as filing Form 8996 to certify it meets its asset requirements.