I got another call last week about someone who wanted to invest in an Opportunity Zone (OZ). Did I ask why? “And they said,” To save taxes and earn more money. “
Okay, I get it and that’s a good answer, but what is the plan? How will you save money on taxes? How much are you going to save? There seems to be a lot of buzz around the OZs, and for good reason. They could be great, but it has to be the right situation and planned correctly. Due to the hype and misunderstanding, I wanted to share my understanding of what OZs are and how you, as an investor, can benefit from them.
Legislation passed in 2017 allows the US Department of the Treasury to create OZ. In 2018 the information on the incentives was released. Because this is so new, it is very misunderstood. The idea is to stimulate economic growth in real estate and jobs by granting tax benefits to investors for investing in businesses or real estate located in certain parts of the city. Zones are determined by the state and approved by the federal government. My understanding is that the only tax benefits are some deferrals and long-term capital gains tax waiver, and there are some hurdles to overcome.
First, an individual cannot invest in a property in an OZ. For an investment to qualify for tax incentives, it must invest in OZ through an opportunity fund (OF). An OF is a taxable entity such as a corporation or partnership, such as an LLC, that invests at least 90% of its capital in OZ. According to the IRS, for an entity to qualify as OF is simply to self-certify by filing a form with the IRS.
The tax benefits can be great. Investors can defer paying income tax if they invest the earnings in an OF. This works much like a 1031 exchange, but it doesn’t need to be a similar exchange, which means you could liquidate other investments, such as stocks, and defer the earnings from them. Tax deferral improves even more with OZs because the amount you pay on profit decreases over time. If you invest in an OZ and hold the investment for 5 years, you will reduce your profit by 10%, which in turn reduces your taxes. For example, if you have a profit of $ 50,000 from the sale of shares that you transfer to an OZ, after 5 years, the reportable profit on which you will pay taxes is reduced by $ 5,000, making the taxable profit of $ 45,000. If you keep the assets for 7 years, the profit is reduced by another 5%. Making the taxable profit $ 42,500. In 2026, you will have to pay taxes on the deferred capital gain, whether you sell the asset or not. However, the big benefit is when you keep the property for 10 years. After 10 years, you will not pay any capital gains for any appreciation of the asset from the day you bought it. So if your investment increases in value by $ 100,000 over 10 years and you sell it, you pay $ 0 in taxes.
It is interesting to be forced to use OF to invest in OZ. From what I can tell it is done this way to attract bigger investments for the biggest impact, but I found nothing to say that you cannot set your own OF to invest in a single property in one OZ. These benefits are great, but the way I see it, they only get a lot better. I wouldn’t specifically invest in an OZ just because of the tax exemption.
Myths of Opportunity Zones: These are the two most common myths about Opportunity Zones that I hear:
I can convert the capital gains to OZ, keep the property for 10 years and never pay taxes on the gain.
It is true that you will never pay taxes on the capital gains of the original investment after 10 years, but you will have to pay taxes on the gains that you transferred in fiscal year 2026. The gains that you enter in an OZ are simply differentiated and will be reduced with the time, but it will never be removed.
I can buy a rental in an OZ to save a lot on taxes.
There are two reasons why this will not work. One of the obstacles to investing in OZ is that you must invest through an OF. Once you identify an investment, you will need to establish a separate LLC, partnership, or corporation to invest in that property and then notify the IRS that your entity qualifies as OF.
A much more confusing hurdle is substantial improvement. Per IRC Sec. 1400Z-2 (d) (2) (D) (I), qualified OZ property held by a qualified OF must meet one of the following requirements:
The original use of the Qualified Opportunity Zone property begins with the Qualified Opportunity Zone fund, or
The Qualified Opportunity Zone Fund substantially improves the property.
The way I understand this is that if you buy a property, you will need to build a new one (new original use) or make major improvements. Recently there was clarity in the definition of “substantially improved”.
To qualify for substantial improvements, you must make improvements that double your base (make improvements that equal the amount paid for the asset) in any 30-month period while the asset is owned. The base subtracts the value of the land, so the improvements must equal the value of the improvements only. For example, let’s say you buy a rental for $ 100,000. According to the county assessor, the value of the land is $ 20,000. To qualify for the tax incentive, you will need to invest another $ 80,000 in the property within a 30-month period sometime in the next 10 years before you can sell the asset.
So what is the strategy?
The obvious strategy is to buy land in OZ and build to hold. Other strategies for real estate investors could be to buy and fight to build townhouses or condos. In those cases, you’ll want to keep some of the units as a rental for at least 10 years. Another option that I can see some creative investors taking advantage of is Access Building Units (ADUs). These are small buildings or additions that are used as additional units or apartments. These are becoming more popular with the rise of Airbnb in many areas, you don’t need to be zoned for multi-family to build them. Due to regulation on short-term rentals, you may need to rent them as long-term rentals, but the number could still work. I can see if you buy a single family home that needs repair, by the time you rehab the house and build an ADU, you might qualify for the tax incentive.
To see a map of the OZs in your area, you can visit the US Treasuries site here.