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Opportunity zones and capital gains: What your clients need to know

Opportunity zones are the hottest trend in the world of commercial real estate. Neighborhoods from New York City to the Bay Area are seeing substantial investment capital because of this program, but like any opportunity, there are pitfalls. While there are many ways to hit a home run with OZ investments, there are also plenty of ways to strikeout. Let's take some time to go over what you need to know about opportunity zones, capital gains and how to protect your clients’ investments in this arena.

What are opportunity zones?

As an accounting or tax professional, I’m going to assume you're familiar with the broad strokes relating to opportunity zones, but if not, here is a quick primer:

Boarded up residential buildings in the Port Morris neighborhood of the Bronx
Boarded up residential buildings in the Port Morris neighborhood of the Bronx

Congress's 2017 Tax Cuts and Jobs Act introduced several changes in how the federal government approaches real estate taxation. One provision of the bill, the Investing in Opportunity Act, created qualified opportunity zones and opportunity funds. These "opportunity zones" were created to help revitalize struggling communities through the use of private capital, rather than direct investment by the federal government. Investors who choose to invest in opportunity zones may benefit from capital gains tax incentives exclusive to this bill, including the ability to defer paying capital gains tax for any OZ-related earnings until April 2027, as long as those investments are held through the end of 2026.

Avoiding OZ pitfalls

Predictably, opportunity zones have grabbed the attention of investors across the country. Many have rushed to deploy capital in designated OZs with little regard to the underlying fundamentals behind their investment, which is a mistake. While tax deferral and the ability to leverage that capital are enticing, investors need to take steps to ensure their investments make sense and that they are not investing only to meet tax criteria.

The best way to avoid this pitfall is to research the foundation of an opportunity zone before investing. It is critical to research the region's economic growth, population growth, employment metrics and all of the other variables that one would traditionally examine before entering a market. Investing in an OZ without regard to the facts on the ground is putting the cart before the horse and can lead to substantial losses or reduced returns over the long term.

OZ tax implications

As mentioned earlier, opportunity zones offer substantial tax benefits as long as you hold the investment for the right amount of time. Any gains accumulated must be invested in a QOZ, or qualified opportunity zone fund, within 180 days to qualify for any tax treatment offered under the legislation.

Investors who hold their OZ fund investments for at least five years before the end of December 2026 may reduce their deferred capital gains liability on invested principal by 10 percent. If they hold that investment for seven years before the end of December 2026, they can reduce their tax liability by 15 percent. Any investors who hold onto their OZ fund investments for 10 years or more will not have to pay capital gains tax on the appreciation in their OZ fund investment, as any gains earned on an investment that’s been held for at least 10 years qualify for permanent exclusion.

Savvy investors can move capital gains from other investment opportunities to generate long-term savings with the right OZ investment. The combination of tax advantages and long-term property appreciation and/or cash flow can be a powerful vehicle for driving returns, which is particularly relevant for real estate investors. The attractiveness of investing in opportunity zones, combined with the affordability of assets in those regions, may generate substantial returns over investments in already sky-high regions like San Francisco, New York City, Seattle and other high cost of living areas.

How to determine if OZ investments are right for your clients

To fully take advantage of OZ benefits, investors should be in it for the long haul. At the very least, they should hold their investment for the minimum five-year period to receive tax deferral, but like many investments, holding for a longer period offers better returns. As an accounting or tax professional, this holding period should be the first variable you examine before recommending an OZ investment to your clients.

Another area to look at is the illiquidity present in the majority of OZ investments. Touching on my earlier point, not holding the investment for the designated time period means that investors will not be able to benefit from the program’s tax advantages. If your client may need to realize their investment before the five-, seven- or 10-year periods before the end date, OZ fund investments might not be for them. While they will benefit from cash flow during the length of their investment, they will not be able to realize any appreciation gains until the holding period is finished.

The bottom line

Opportunity zones present a phenomenal opportunity for investors, but so did the California Gold Rush, and the majority of people who took advantage of that phenomenon ended up losing money. To ensure you are able to protect your clients and get them the tax advantages they deserve, it is critical that you view an opportunity zone investment with the same lens you would any other investment, while still taking account of the substantial tax benefits offered by the program. In investing, as in life, there are no sure things. OZ funds as an investment vehicle bear the same risks and rewards as any other real estate investment, just with added tax benefits. The important thing is to proceed with caution and not get swept up in all the hype surrounding this new investment avenue.