Opportunity zones are the new "ruby slippers" in the investment world. It is a very powerful, but limited, tax break that can provide significant economic benefit to investors.
The opportunity zone program was created to incentivize investment into certain economically depressed areas of the United States.
The tax benefit is limited solely to taxpayers who have recently realized a significant capital gain. Generally, this will mean founders or investors who recently have sold stock, partnership interests or other property as part of a financing or exit. Without untaxed capital gains, you may not take advantage of this tax break.
If a taxpayer invests capital gains into an opportunity zone fund (more on that below), the taxpayer obtains the following benefits:
- Deferral of the tax on capital gains until earlier of (i) disposition of the taxpayer's interest in the opportunity zone fund; or (ii) December 31, 2026
- 10% discount on the amount of capital gains subject to tax (if held 5 years)
- 15% discount on the amount of capital gains subject to tax (if held 7 years)
- No tax on the appreciation of the interest in the opportunity zone fund (if held 10 years)
Certain key time periods are important:
- December 22, 2017: The date Sections 1400Z-1 and 1400Z-2, which govern the opportunity zone program, were added to the Internal Revenue Code
- 180 days: A taxpayer who has a capital gain realization event must invest the gain (or a portion thereof) into a qualified opportunity zone fund within this time period. There is no relief for missing the 180-day window
- 5 year period: Once the investment in the opportunity zone fund has been held for at least 5 years (and prior to December 31, 2026), the tax basis of the invested gain is increased by 10% of the deferred gain. In other words, after 5 years an investor will get a 10% discount on the amount capital gains that are taxed when tax ultimately has to be paid upon the earlier of a disposition or December 31, 2026
- 7 year period: Once the investment in the opportunity zone fund has been held for at least 7 years (and prior to December 31, 2026), the tax basis of the investment is increased by an additional 5% of the deferred gain (for a total 15% increase). In other words, after 7 years an investor will get a 15% discount on the capital gains that are taxed when it ultimately has to be paid upon the earlier of a disposition or December 31, 2026. Investments made after 2019 will not be able to take advantage of this benefit
- December 31, 2026: The date the "initial capital gains" that were invested in the opportunity zone fund must be taxed. This is a strict date (a sort of "day of reckoning") for acceleration of the deferred capital gain, regardless of how long the investor has invested in the opportunity zone fund
- 10 year period: Once the investment in the opportunity zone fund has been held for at least 10 years, any appreciation above and beyond the initial capital gains (which were taxed at the end of 2026) is tax-free
An opportunity zone fund must own property in an opportunity zone or invest in a business located in (or has a substantial amount of its property or operations in) an opportunity zone. The IRS recently published (and subsequently updated) a list of opportunity zones.
How has Cooley helped (and can help) clients take advantage of this tax break?
- Counseled investors and founders that have recently cashed out in large financings/exits on how to take advantage of this tax break
- Connected clients with specific opportunity zone funds (Cooley clients and friends of Cooley)
- Created opportunity zone funds for our clients for their own investment
- Created opportunity zone funds for developers to attract capital for their investments
- Helped our clients expand or relocate their businesses into opportunity zones to attract additional capital from opportunity zone funds
On July 1 2019, Florene Founder sells 100% of her interests in Fashion Forward, LLC to a LMVH for $110 million. She had $10 million of tax basis in her LLC interests, so she will have capital gains of $100 million. Before December 27, 2019 (within 180 days of the sale), she makes a $100 million investment in a qualified opportunity zone fund ("OZFund"). At year end, she will NOT have to pay capital gains on the $100 million of capital gains that she invested in the OZFund. The fair market value of her interest in OZFund is $100 million, and her tax basis in OZFund is deemed to be zero.
On December 27, 2024, when the fair market value of her interest in OZFund is $140 million, she meets the 5-year holding period and her tax basis in the OZFund is "stepped up" to $10 million. Thus, if she were to sell at any time thereafter, she would not pay tax on the first $10 million. No tax is due at this point.
On December 27, 2026, when the fair market value of her interest in OZFund is $160 million, she meets the 7-year holding period and her tax basis in the OZFund is "stepped up" from $10 million to $15 million. No tax is due at this point.
On December 31, 2026, when the value of her interest in OZFund is still $160 million, Florene must pay the capital gains tax on the $100 million of gain she deferred in 2019 (not the full value of the investment). Since her tax basis was stepped up to $15 million, she only has to pay capital gains tax on $85 million of gain ($100 million deferred capital gain – $15 million tax basis). Her tax basis in the OZFund is now stepped up to $100 million.
On December 27, 2029, when her interests in OZFund is worth $220 million, she meets the special 10-year holding period. This means that ANY and ALL gain above and beyond the $100 million that she initially invested is tax free. She can sell at that point (and take all $220 million tax free) or she can continue to hold as the value increases in the future (since all gains are tax free).
The Technical Nitty-Gritty
(You should leave this to the experts, but if you really want to know):
- A qualified opportunity zone fund can be an LLC or a corporation (unlike QSBS, which must be a C corporation) with at least 90% of its assets invested in a qualified opportunity zone property (percentage is tested every 6 months)
- Qualified opportunity zone property is an equity (not debt) investment in either (i) a qualified opportunity zone entity ("OZ Entity") or (ii) qualified opportunity zone business property ("OZ Business Property")
- An OZ Entity can be a domestic corporation (C or S), LLC or partnership that is engaged in a qualified opportunity zone business ("OZ Business")
- An OZ Business is a trade or business in which:
- (i) at least 70% of the tangible property owned or leased by the taxpayer is OZ Business Property;
- (ii) at least 50% of the total gross income of the entity is derived from the active conduct of the business;
- (iii) a substantial portion (40%) of the intangible property of the entity is used in the active conduct of the business; and
- (iv) less than 5% of the average tax basis of the property is attributable to certain financial property (there are special rules to allow for some reasonable working capital).
- In addition, the business cannot be a golf course, country club, massage parlor, hot tub facility, racetrack, gambling establishment or liquor store.
- OZ Business Property is tangible property purchased for use in a trade or business that is located within an opportunity zone, and:
- the property in the opportunity zone is original use (new property), or
- the property is existing property but the fund or business "substantially improves" the property (i.e., over the next 30 months it must invest at least the same amount as the original investment).
- Qualification as an opportunity zone fund, OZ Business, or opportunity zone business property is highly technical. If your discussions get to the point where a client is trying to form a fund or qualify an entity or specific property, you should talk to Cooley team members who have experience in this area: