What Are the Qualified Opportunity Zone Tax Benefits?

A Qualified Opportunity Zone (QOZ) is an economically distressed community where new investments can receive preferential tax treatment. Designated in all 50 states, D.C., and U.S. territories, the program was created by the Tax Cuts and Jobs Act of 2017 to spur economic development. It encourages long-term investment by offering tax incentives to investors.

Investors access these benefits by placing capital gains into a Qualified Opportunity Fund (QOF), an investment vehicle organized to invest in QOZ property. This structure directs private capital toward projects that foster job creation and stimulate economic activity in under-resourced communities.

The Core Tax Benefits of a QOZ Investment

Temporary Deferral

A primary benefit of a QOZ investment is the ability to temporarily defer federal taxes on capital gains. When you realize a capital gain from selling an asset, you can postpone the tax by reinvesting the gain into a QOF. This deferral lasts until the QOF investment is sold or until December 31, 2026, whichever is earlier.

The tax on the original gain will be due with your 2026 tax return. For example, if you have a $200,000 capital gain from a sale, you can defer the tax on that amount by investing $200,000 into a QOF. This allows capital that would have been paid in taxes to be invested instead.

Basis Step-Up on Original Gain

The QOZ program previously offered a basis step-up that reduced the original deferred gain for investments held for five or seven years. However, these benefits are no longer available for new investments. The deadlines to qualify for the 10% and 15% basis increases passed in 2021 and 2019, respectively.

Permanent Exclusion of QOF Appreciation

The most significant benefit of the QOZ program is the potential for permanent tax exclusion on the appreciation of the QOF investment. If you hold your QOF investment for at least 10 years, you can elect to increase the basis of your investment to its fair market value on the date it is sold. This means any capital gain accrued on the QOF investment is tax-free.

For example, if you defer a $100,000 capital gain by investing it into a QOF and the investment grows to $250,000 after 11 years, you can sell it and elect to step up your basis to the $250,000 fair market value. As a result, the $150,000 in appreciation is not subject to federal capital gains tax.

Requirements for a Qualifying Investment

Eligible Gains

To participate in the QOZ program, an investor must start with an eligible capital gain. This includes both short-term and long-term capital gains from the sale or exchange of property, such as stocks, bonds, real estate, or a privately held business, to an unrelated person. Only the gain portion of any sale proceeds qualifies for the tax benefits.

The program also allows for the investment of qualified Section 1231 gains. These are gains from the sale of property used in a trade or business, such as commercial real estate or equipment. These gains are typically reported on Form 4797, Sales of Business Property.

The 180-Day Investment Window

A strict 180-day rule governs QOZ investments. An investor must reinvest an eligible capital gain into a QOF within 180 days from the date of the sale that generated the gain. Missing this deadline means the gain is no longer eligible for the program’s tax benefits.

For gains passed through from entities like partnerships or S corporations, the rules offer more flexibility. An investor receiving a gain on a Schedule K-1 can choose to start their 180-day window on the date the entity sold the asset, the last day of the entity’s tax year, or the due date of the entity’s tax return, without extensions.

The Qualified Opportunity Fund (QOF)

Investors do not invest directly into a QOZ but must use a Qualified Opportunity Fund. A QOF is a U.S. corporation or partnership organized to invest in QOZ property. These funds must hold at least 90% of their assets in qualified opportunity zone property, a standard that is tested twice a year.

There are two primary ways to invest through a QOF. The most common method is to invest in a professionally managed QOF created by a financial institution. Alternatively, an individual or group can form their own self-certified QOF by establishing a partnership or corporation and filing Form 8996 with the IRS.

Making the Deferral Election on Your Tax Return

Form 8949, Sales and Other Dispositions of Capital Assets

To defer the gain, you must make an election on Form 8949, Sales and Other Dispositions of Capital Assets, with your federal income tax return. This form is used to report the original sale that generated the capital gain. The form’s instructions detail how to report the transaction and use a specific code to signify that the gain is being rolled over into a QOF.

Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments

You must also file Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments. This form is filed for the tax year the QOF investment is first made and for every subsequent year the investment is held, even if no new transactions occur. It serves as a tracking document for the IRS.

On the initial form, you will report the QOF’s Employer Identification Number (EIN), the acquisition date, and the amount of gain you deferred. The information on this form must align with the deferral election made on Form 8949. Failure to file Form 8997 annually can result in penalties.

Maintaining the Investment and Realizing Full Benefits

Inclusion Events

The tax deferral on the original capital gain can end before the December 31, 2026, deadline if an “inclusion event” occurs. An inclusion event is any transaction that reduces or terminates the investor’s equity interest in the QOF. Common examples include selling or gifting the QOF investment or the liquidation of the fund.

When an inclusion event happens, the investor must recognize the deferred gain. The amount of gain to include in income is the lesser of the remaining deferred gain or the investment’s fair market value at the time of the event, minus its basis. This gain is reported on Form 8949 for the year the inclusion event took place.

Securing the 10-Year Tax-Free Gain

After holding a QOF investment for at least 10 years, you can make a special election upon its sale to eliminate tax on the appreciation. This is done on Form 8949 for the year of the sale. The election allows you to step up the basis of your QOF investment to its fair market value on the sale date, which results in zero taxable gain from the sale.