In addition to providing broad-based tax relief, the Tax Cuts and Jobs Act created Opportunity Zones (OZs), drawn from legislation introduced by Senator Tim Scott (S.293) and former Representative Pat Tiberi (H.R.828), the Investing in Opportunity Act. OZs encourage long-term private capital investment to revitalize low-income areas.
Governors, not federal bureaucrats select Opportunity Zones. Under the new law, governors choose their state’s OZs, which must be either a Low-Income Community (LIC) census tract or adjacent to one. The LIC must have one of the following characteristics:[i]- A poverty rate of 20% or higher.
- If in a metropolitan area, median family income below 80% of the greater of the statewide or the metropolitan area median family income.
- If outside a metropolitan area, median family income below 80% of the median statewide family income.
Additionally, a non-LIC census tract is eligible if it:1. is contiguous with an LIC, and
2. has a median family income not exceeding 125% of the neighboring LIC’s median family income. Only 5% of total designated census tracts can be non-LIC.[ii]
Governors may select up to 25% of the state’s low-income census tracts as OZs, or 25 total if the state’s total number of LICs is less than 100. The U.S. Treasury Department has validated all OZs.
Opportunity Zones offer flexibility. Each low-income community has its own set of unique challenges. OZs allow the private sector and local officials to collaborate on the types of investments that would best meet those needs instead of restricting investments to certain types of activities.
Private investments flow into communities in need of capital. Investors can reinvest capital gains from another investment into an OZ and temporarily defer paying capital gains taxes on the original investment. Other tax benefits accrue the longer the investment is held in an OZ. Investments in OZs must be made through a qualified “Opportunity Fund,” which is a partnership or corporation investment vehicle that is solely used for OZ investments. Any taxpayer can self-certify and create an Opportunity Fund simply by completing the necessary IRS forms.[iii]
Incentives to invest in distressed areas. Capital gains tax relief grows the longer an investment is held in OZs.
- If the investment is held between 5-7 years:
The taxable portion of the initial investment is reduced by 10%. Thus, if the investor originally owed taxes on $100, the taxable amount from the original investment would be reduced to $90.
- If the investment is held between 7-10 years:
The treatment is the same as for investments held 5-7 years, except that the taxable portion from the initial investment is reduced by an additional 5%. Thus, only $85 out of the $100 OZ investment is taxable.[i]
- If the investment is held for at least 10 years:
Investors are relieved from paying capital gains taxes on the appreciation in the OZ investment. These investors may get all three benefits—temporary capital gains deferral for the original investment, reduced capital gains taxes on the original investment (if the investment is made prior to December 31, 2021), and no capital gains taxes on the OZ investment’s appreciation.
An illustration. Table 1 is an example of a 2018 $100,000 investment into an OZ assuming a 7% annual rate of return.[i] Columns (4) and (5) show the taxable amounts if the investment is sold in the column (2) year.
[i] “Tax Incentives for Opportunity Zones: In Brief,” Congressional Research Service, April 5, 2018, p. 1, footnote 5. http://www.crs.gov/Reports/R45152?source=search&guid=784e20e9cea1433d8dab119fec50d144&index=0
[ii] Amazon’s HQ2 will be located in a Long Island, NY non-LIC tract, however, due to OZ mechanics, tax benefits may not apply. “HQ2 and Opportunity Zones: The Big Picture,” Economic Innovation Group, November 16, 2018. https://eig.org/news/hq2-and-opportunity-zones-the-big-picture
[iii] “Opportunity Zones Frequently Asked Questions,” Internal Revenue Service. https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
[iv] The 5-year and 7-year 10% and 15% reductions will not apply to investments made after December 31, 2021 and December 31, 2019, respectively.
[v] A similar example and explanation are contained in the CRS brief cited in endnote 1.