By R. Darden Bell, III, Tax Senior Manager | Real Estate & Construction Industry Team
Opportunity zones have been one of the hottest topics from the Tax Cuts and Jobs Act (TCJA). These new rules provide investors the ability to defer taxable gains by investing in economically distressed communities chosen by each state’s governor. The U.S. Treasury has already issued two sets of proposed regulations on administration of opportunity zone investments and opportunity zone funds. Even with all of the publicity, expert analysis, and regulations issued on this topic, there are still some misperceptions circulating. The intent of this article is to clarify those misperceptions and help taxpayers make informed decisions.
10 Opportunity Zone Investment Misperceptions
1. Investors can invest cash that is not associated with a deferred gain in a Qualified Opportunity Zone Fund (QOF) and still take advantage of the step up in basis to fair market value with a future sale that occurs 10 years or more from the date of their investment.
Investors have to make the initial gain deferral election to be able to make the second basis-to-fair market value election down the road. In other words, any investment in a QOF that is not tied to a deferred gain from a prior sale is not eligible for any of the tax benefits related to opportunity zones.
2. A taxpayer can permanently exclude the entire original deferred gain as long as they hold the QOF investment for at least 10 years thanks to the basis to fair market value increase that triggers with a future sale.
The basis to fair market value increase only applies to the appreciation of the QOF investment itself. None of the original deferred gain will be impacted by the 10-year basis to fair market value increase. 10% of the original deferred gain is eliminated once the QOF investment is held for five years, another 5% is eliminated once the holding period reaches seven years, and the remaining 85% becomes taxable in the 2026 tax year.
3. Any type of gain, including Sec. 1231 gain, can be utilized to make an opportunity zone investment.
Only capital gains can be utilized to make investments in a QOF. Section 1231 gains can be treated as capital gains, but they can also be re-characterized and treated as ordinary gains or be offset by other Section 1231 losses. If a taxpayer has Section 1231 gains, they must first go through the netting process at the individual tax level to determine how much of those Section 1231 gains end up being treated as capital gains. Any gains re-characterized due to Section 1245 or Section 1250 recapture are ineligible for gain deferral. Only the portion of Section 1231 gains that would ultimately be treated as capital gains are eligible for opportunity zone deferral investments. Additionally, even though short-term capital gains are taxed at ordinary income rates, they are still considered capital gains and are eligible for opportunity zone deferral investments.
4. The 180-day period for making required investments in a QOF starts on the date of the original sale.
The statement above holds true when a taxpayer sells non-business assets that they personally hold, such as stock or land. However, if Section 1231 gains are involved, the 180-day period does not begin until the last day of the taxable year. The regulations indicate that the 180-day period begins on the date on which the gain would be recognized for Federal income tax purposes. The regulations provide the 180-day window cannot begin until the last day of the tax year because of the netting process that is required to determine how much of a taxpayer’s Section 1231 gains would be treated as capital gains. However, the taxpayer can elect to start their 180-day window sooner should they have the necessary information to do so.
5. Taxpayers will not be able to deduct any losses that may be passed through to them from an opportunity zone fund due to basis limitations since their basis in their investment is automatically set to $0 when the investment is made.
While investors do in fact have $0 tax basis in their investment at the outset, partnership investors still receive basis from liabilities allocated to them by the partnership. If the liabilities allocated to a taxpayer on their K-1 are recourse or qualified non-recourse liabilities, they should presumably have sufficient tax basis and at-risk debt basis under Section 465 in their investment to deduct the losses passed through to them from the QOF. Additionally, when the taxpayer’s basis is increased by 10% of the deferred gain amount at the five-year mark and by another 5% at the seven-year mark, those basis increases should free up any losses that had previously been suspended.
6. The liquidity problem that occurs in 2026/2027 when the tax becomes due on any remaining deferred gains makes these investments problematic.
There’s no denying the cash flow issue that may occur in 2027 when the tax becomes due on any remaining deferred gains. Fortunately, the second batch of proposed regulations allow for the use of debt-financed distributions on a tax free basis so long as they do not trigger distributions in excess of basis or the disguised sale rules. In this scenario, a QOF could leverage up in 2026 and distribute funds to the investors tax-free to help them cover the taxes that will be due with the filing of investors’ 2026 tax returns.
7. An investor has to acquire an interest in a QOF directly from the QOF to take advantage of the tax benefits.
The second batch of proposed regulations allow taxpayers to acquire an equity interest in a QOF from a person other than the QOF itself. In this scenario, the amount eligible for the taxpayer’s initial deferral election is the amount of cash, or the fair market value of other property, the taxpayer exchanged for the eligible interest in the QOF. This allows for a secondary market to evolve for the sale or exchange of QOF interests should initial QOF investors wish to sell their investments.
8. Opportunity zone tax benefits apply at both the Federal and the State level.
It depends on the state in which the taxpayer resides. Taxpayers need to check the rules of their home state to determine whether or not their state conforms to TCJA. States that do conform to TCJA by default conform to the benefits of opportunity zones unless their state specifically indicates they do not. If a state does not conform to the TCJA and does not recognize opportunity zone investments, taxpayers will likely have to pay state income taxes on the amount of gain they are attempting to defer using opportunity zone investments. Virginia generally conforms to the TCJA and does not list opportunity zones as a specific de-conforming item, so Virginia residents should receive both Federal and State tax benefits from making opportunity zone investments.
9. An investor has to sell their interest in the QOF to have the ability to elect to step up the basis to fair market value when there is a sale after ten years.
If the second batch of regulations are finalized as drafted, they will permit investors that hold an interest in a QOF for at least 10 years to elect to exclude capital gain allocated to them when the fund sells its qualified opportunity zone property after such 10 year period. In other words, the investor won’t have to sell their interest in the QOF. Instead, they will be able to apply their election to increase basis to fair market value to the gains allocated to them from the sale of underlying QOF assets. This only applies to capital gain income, and this part of the proposed regulations cannot be relied upon until they are finalized.
10. The current capital gain tax rates will apply to the deferred capital gains recognized on taxpayers’ 2026 tax returns.
Whatever capital gain tax rates are in place for the 2026 tax year is what will apply to the deferred gains recognized in 2026. If the government chooses to increase capital gains tax rates between now and then, taxpayers will end up paying the higher rates, which will erode the benefit of the 10%/15% permanent tax exclusion from holding the QOF investment for five and seven years respectively.
Investing in a Qualified Opportunity Zone Fund can provide great returns for savvy investors, but as with all forms of investment, there are risk areas to navigate as well. The proposed regulations have provided clarity on many critical aspects of the program, but there are still questions that need to be addressed by the final regulations. Should you need assistance navigating the waters of opportunity zones, don’t hesitate to reach out to your Opportunity Advisor here at Keiter or Email our Real Estate & Construction Team. We are here to help.
Additional Opportunity Zone Resources
- How to Qualify as an Opportunity Zone Business
- New Tax Benefits for Qualified Opportunity Zone Investments
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.