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Opportunity Zones Explained

What advisors need to know about this new policy and the tax benefits for their clients.

By Adam Hooper

Opportunity Zones is a new community development program established by Congress in the Tax Cuts and Jobs Act of 2017 to encourage long-term investments in low-income urban and rural communities nationwide.

The idea originated from tech billionaire Sean Parker, the former president of Facebook and creator of Napster. In 2013, Mr. Parker enlisted powerful allies and formed the Economic Innovation Group, a Washington think tank to help him press the policy into law.

The program essentially rewards reinvestment of profit into “Opportunity Zones” defined as low-income census tracts selected by state governors and certified by the U.S. Treasury Department.

There are roughly 8,700 Opportunity Zones throughout the U.S., providing real estate investors with the opportunity to defer or even eliminate capital gains tax. 

The Triple-Threat Tax Treatment

Capital gains tax deferral, step-up in basis, and capital gains tax elimination are the triple-threat tax advantages real estate investors may see with investment in Opportunity Zones.

Derek Uldricks, President of Virtua Partners, a global private-equity real estate investment firm that recently created its first opportunity zone fund, demonstrates the tax benefits that can be realized by investors.

Assume an investor has a $1 million gain in Apple stocks and decides to sell. To keep it simple, let’s also assume the investor is in a 20 percent tax bracket, totaling $200,000 in capital gains tax. But instead of paying, the investor reinvests the $1 million in an Opportunity Fund.

Here’s what happens next:

  • Deferment of gains: By investing those gains in the Opportunity Fund, the tax due on those gains is deferred until the earlier of selling the investor’s interest in the Fund or December 31, 2026.
  • If the investor holds the investment for 5 years: That payment of $200,000 is completely deferred, plus the investor gets a 10 percent step-up in basis on the original gain deferred. So now the investor pays $180,000, saving $20,000 in capital gains taxes.
  • If the investor holds for 7 years: They receive an additional step-up in original basis of 5 percent, and the capital gains tax bill goes down to $170,000, saving $30,000 on the taxes owed from the investor’s initial gain.
  • If the investor holds for more than 10 years: the investor pays ZERO capital gains tax on the appreciation of that asset.

Let’s break down the last point.

If the investor holds the $1 million investment for 10 years, any gains made on that investment are tax-free. The investor pays ZERO capital gains tax on all of the appreciation above and beyond the $1 million. So even if the $1 million turned into $3 million, that $2 million in lift achieved through investing in the Opportunity Fund is tax-free.

Essentially, the federal government is allowing the investor to keep the capital gains at 0 percent interest and use those funds to invest in one of these Opportunity Zone projects for 10 years. After 10 years, the investor pays no capital gains tax on the appreciation of the asset.

Does It Beat a 1031 Exchange?

Some have called the 1031 exchange “a perpetual deferral until the ultimate exit.” If at any point an investor sells an asset, they are on the hook for the gains. This leaves most investors holding their real estate until death (the ultimate exit) so that at least their heirs get the step-up in basis.

With Opportunity Zones, investors don’t have to die to eliminate the capital gains tax burden. After 10 years, the entire basis automatically steps up. And investors don’t have to jump through hoops to get it.

This includes saving taxes on any depreciation of the asset, unlike the 1031, where an investor may have to pay “depreciation recapture.” In essence, an investor can use depreciation to offset income in the rest of the portfolio.

Due to the nature of the investment vehicle, Opportunity Zone investments allow more creative use of capital. With a 1031, it’s all or nothing. The initial investment is locked in along with the capital gains accrued over the life of the investment. And it all goes into the rollover asset chosen next.

This is not the case when investing in Opportunity Zones. Going back to the Apple stock example, there was a theoretical gain of $1 million. But that’s just the gain. The investor may have had another $200,000 in there that was the initial investment or “initial basis”: the investment principal that can be taken out without penalty.

This is another huge advantage compared to the 1031. Investors can take the initial basis out, in this case $200,000, to do with it what they want.

Breaking Down the Investment Vehicle: The Opportunity Fund

We’ve now explained how Opportunity Zones came into being and what the tax advantages are. But how exactly do investors go about investing in these zones? The answer is “Opportunity Funds.”

According to EIG:

“Opportunity Funds are private sector investment vehicles that invest at least 90 percent of their capital in Opportunity Zones. The fund model will enable a broad array of investors to pool their resources in Opportunity Zones, increasing the scale of investments going to underserved areas.”

So, investors can’t just purchase a property in an Opportunity Zone and expect the tax advantages. Nor can they team up with a Sponsor or Fund Manager who doesn’t abide by the guidelines for Opportunity Funds that will be set forth by the Treasury Board and IRS later this year.

The tax incentive is for investors to re-invest their unrealized capital gains into Opportunity Funds within 180 days. And these funds must be dedicated to investing into Opportunity Zones designated by the Governors of every U.S. state and territory.

This new investment vehicle will be organized as a corporation or a partnership and can be any array of equity investments in a variety of different sectors. EIG explains.

“This is critical, because low-income communities have a wide range of needs, and Opportunity Zones at their best will recruit investments in a variety of mutually enforcing enterprises that together improve the equilibrium of the local community.”

There are certain rules that are still being fleshed out. What we know so far in terms of guidelines, the Opportunity Funds:

  • Must be certified by the U.S. Treasury Department.
  • Must be organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone property.
  • Must hold at least 90 percent of their assets in a Qualified Opportunity Zone property, which includes newly issued stock, partnership interests or business property in a Qualified Opportunity Zone business.
  • Must have investments are limited to equity investments in businesses, real estate and business assets that are located in a Qualified Opportunity Zone. Loans are not eligible for the tax incentives. Opportunity Fund investments in real estate are subject to a substantial rehabilitation requirement.

Ultimately, Opportunity Zones is a game changer that will provide significant tax benefits for real estate investors while looking to revitalize America's depressed communities through social impact investments.

Adam Hooper is Co-Founder and CEO of RealCrowd.

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