Opportunity Zones May Provide Significant After-Tax Benefits to Investors

• July 2, 2024
• Brian Duren

Through our many years of experience working with investors and project sponsors in the opportunity zone (OZ) community, we’ve learned a few things that are helpful in assessing a potential OZ project or investment alternative. Among those is the general observation that can be seen when an OZ project is measured on an after-tax basis and compared to other traditional investments.

In a recent article, we explored the tax benefits available from the OZ incentive on a deeper level and highlighted several key distinguishing factors that should be considered by investors and sponsors alike when evaluating current and future OZ projects. Read the full article here.

Benefits of investing in opportunity zones

Opportunity zone investors generally receive up to three distinct tax benefits:

1. Temporary deferral of capital gains invested in a qualified opportunity fund (QOF) through December 31, 2026 (or earlier if the QOF investment is sold)
2. For investments made before December 31, 2021, 10% or 15% permanent reduction in the deferred gains if the taxpayer held the QOF investment for at least five or seven years, respectively
3. Total and permanent exclusion of taxes on future gains from the disposition of the QOF investments made before December 31, 2026 if the taxpayer holds such investment for at least 10 years

Breaking down these tax benefits illustrates how the OZ incentive can create significant after-tax economic value. For example, the temporary deferral of capital gains can provide investors with extra liquidity until taxes are paid for the 2026 tax year — which is noteworthy in today’s environment of high interest rates.

Also, for early OZ investors, a permanent reduction in the deferred gain of either 10% or 15% will mean slightly lower tax liabilities in 2026 when the deferred gain is recognized.

Add further value with depreciation strategies

However, the most lucrative benefit — the ability to exclude future gain from taxation — represents a distinctive opportunity to significantly add value to the investment. To fully understand the magnitude of this benefit, we need to understand how depreciation strategies can amplify the tax-free nature of the future gain.

Depreciation deductions, including accelerated depreciation and cost segregation strategies, play an important role in reducing taxable income in the early years of a real estate project’s life cycle. However, since depreciation reduces the tax basis of the underlying property, it exposes the project to higher gains in the future when the property is sold.

In an OZ structure, when a project is sold after meeting the 10-year holding requirement, all gain may be excluded, including gain resulting from prior depreciation deductions. This means that investors can not only exclude gain resulting from the appreciation of their investment over its original cost basis, but they can also eliminate gain related to depreciation recapture.

The permanent tax benefits created by excluding gain from the sale of an OZ investment after 10 years creates significant after-tax value that should not be ignored. Whether you are assessing your first OZ investment or your next one, analyzing the underlying project through an after-tax lens may aid making informed decisions about the full benefits of opportunity zones.

How we can help

Our OZ team members are here to help you analyze your opportunity zone project. We have deep experience in both OZ and the broader real estate industry and can offer insights about how OZ tax benefits affect your project.

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