The perks may be even greater for serial entrepreneurs, owners of improved commercial real estate, and those investing in new or existing businesses located in Opportunity Zones.
Back in May, Treasury released a second set of Opportunity Zone regulations (the “Second Tranche”) that provided better guidance on how Opportunity Zones will operate for business operators, real estate developers, and landlords. The new regulations also clear up a lot of confusion that initially surrounded how Opportunity Zones would work, deadlines to meet, holding periods, and more.
Still, a lot of confusion exists, and we routinely receive questions about the benefits of Opportunity Zones and how to fully take advantage of this capital gains deferral program. Everyone seems to get the gist, that you can earn tax breaks for investing in areas tagged as needing an economic boost, but the details are fuzzy after that.
In no particular order, here are the 5 most beneficial aspects of the Opportunity Zone program that even the experts often miss:
1. A four-year replacement window for 1031 exchanges.
In a 1031 exchange, sellers of real property the can defer taxes due on a sale if the seller identifies another real property within 45 days of the sale and reinvests in that property within 180 days. There is no wiggle room on those deadlines.
An Opportunity Zone transaction, on the other hand, gives taxpayers additional time to make replacement property decisions -- 48 months or more. That’s an incredibly attractive alternative to 180 days. The extra time allows for ground-up construction as the replacement property, a virtual impossibility in a traditional 1031. In addition, unlike a traditional 1031, an OZ investor is also only required/allowed to reinvest the capital gains from their investment, not the entire proceeds. This puts a lot more money back in their pocket.
Note that gains Opportunity Zone program reinvestments will be recognized in 2026 whether or not the replacement property is still held. Further, a 1031 structure for a real estate disposition will benefit residents of states that have not yet conformed to the OZ program. This includes North Carolina and several other states -- California, Arizona, Hawaii, Massachusetts, Minnesota, and Pennsylvania.
2. Easier departure from partnerships.
It’s not too uncommon for partners (family or otherwise) to desire to part ways on an investment. People just see things differently over time -- one wanting to cash-out and the other looking to structure a 1031 transaction and reinvest. Things get tricky when that happens. A sale would trigger a capital gain for each partner, and a 1031 would tie-up equity. That’s typically where the fighting begins.
The Opportunity Zone makes splitting up easier by allowing all parties to sell their interests and have the resulting gain flow to each partner on their year-end K-1. Each partner would have the choice of just pocketing that money or electing under the OZ program to invest their individual gain into a QOF within 180. Of course, this assumes that the partnership does not elect OZ treatment at the entity level. Still, it’s a much more peaceful and easier approach to “splitting up”. Everyone gets what they want.
3. Extracting assets from an S-corp
S corps are the popular choice for LLCs and partnerships, but there are disadvantages to them, including “inside” tax basis of assets held in the S corp retaining their historic cost basis upon the sale of the company or death of a shareholder. A step-up is generally not possible for buyers unless the buyer and seller agree to make 338(h)(10) elections. This is why many advisors suggest not placing appreciating assets into S corps.
The Opportunity Zone program can provide a solution to this problem. By electing OZ treatment at the shareholder level for the gain, the owners can effectively strip the asset from within the S corp while deferring the gain (until 2026). This is because the property in question is now owned outside the S corporation. In the event of a ground-up construction project, the shareholders can take up to 30 months or more to deploy the funds.
You’ll have to weigh this strategy against a 1031 exchange, which offers unlimited deferral of capital gains and also allows gain deferral for all states, but your CPA should be able to run those numbers for you easily and help you make the decision.
4. Doing business in Opportunity Zones.
People tend to think of Opportunity Zones only in terms of real estate, but the new “Second Tranche” regulations clarify how Qualified Opportunity Zone Businesses (QOZBs) can deploy their funds under the working capital safe harbor rules. This provides a unique opportunity for anyone seeking to start, purchase, or move a business into an Opportunity Zone.
Taxpayers can initially form the QOZB as an LLC that’s taxed as a partnership, which then converts to a C corp after startup losses have been incurred. This assumes that the C corp conversion occurs before the entity’s value grows to over $50 million dollars. Before electing into C corp status, taxpayers must evaluate the impact of double taxation and the loss of a tax step-up to the buyer in a sale transaction.
Within five years of becoming a C corp, the entity can be sold and up to 100% of the tax gain can be excluded, provided the gain doesn’t exceed the limits. Some states, like California, do not conform, but the majority do. Again, consult with your CPA on those limits and your state’s compliance with the program.
5. Leveraging debt in a Qualified Opportunity Fund (QOF)
The “Second Tranche” clarified the way debt is treated in a QOF. When a QOF is formed as a partnership, the investor’s share of a mortgage or other liability is treated as a capital contribution/basis increase to the extent that the Qualified Opportunity Fund (or underlying Qualified Opportunity Zone business) has debt that is allocated to the partners or members. This basis increase allows QOF investors to claim tax losses flowing through the entity. The regulations also clarify that the debt layer is also eligible for a full step-up to fair market value in year 10.
Note that many Opportunity Zones also fall into other federal, state, and local tax incentive programs (think property tax, payroll tax, income tax breaks, government grants, and employee training programs). We urge you to work with a CPA who fully understands all of these programs and can help you maximize them all.
If you’re seeking to invest capital gains, an Opportunity Zone may be the right solution. OZ areas abound nationwide, and there’s likely several right in your own backyard. If you need help identifying possibilities, we’re here to help.
