Opportunity Zones 2.0 – Back to the Land of OZ

OZ 1.0

First, for those new to the Land of OZ, here is a brief recap of the original OZ Program.

Tax benefits

Under OZ 1.0, a taxpayer that contributes eligible gain amounts into a qualified opportunity fund (“QOF”) is entitled to three primary federal income tax benefits:

1. Deferral - Deferral of the gain until December 31, 2026 (or earlier if the taxpayer disposes of the investment),
2. Basis Step Up - A tax basis step up of 10% or 15% of the eligible gain amount if the contribution to a QOF was made prior to 2020 or 2022, respectively (which translates to a permanent exclusion of those amounts from taxable income), and
3. 10-Year Gain Exclusion - Exclusion of any gain recognized on the new OZ investment if the interest in the QOF has been held for at least ten years.

The tax basis step up benefit expired several years ago, and the deferral benefit has become less valuable the closer we get to 2026. Any new gains invested into QOFs remain eligible for the 10-year benefit. The existing law expires with respect to any gain recognized after 2026.

OZ investment structures

A QOF has to invest, directly or indirectly, in new property or businesses located in qualified opportunity zones (“QOZs”) which, under the existing law, were designated based on 2010 census results, and QOZ designations remain in effect until December 31, 2028. There are numerous requirements for QOFs, including an asset test which is measured twice a year. For real estate projects, qualifying property includes new original use property (ground up development) and substantially improved property (where additional capital improvements are made to existing buildings in an amount at least equal to the initial cost basis of the building).

OBBBA / OZ 2.0

Tax benefits

All 3 tax benefits are back on the table and available to any taxpayer that invests in a QOF in January 2027 or later.

1. Deferral- Unlike existing law, which provides a fixed December 31, 2026 gain recognition date for all outstanding deferrals, the OBBBA provides a 5-year rolling deferral period that begins on the date that a taxpayer makes its first contribution to a QOF. So regardless of when a taxpayer invests in a QOF, gain is recognized upon the earlier of an inclusion event or five years post-investment.
2. Basis Step Up- If the taxpayer has held its investment in the QOF for the entire 5-year deferral period, it also benefits from a tax basis step-up equal to 10% (or 30% in the case of a qualified rural opportunity fund (a “QROF”), as discussed below) of the amount of gain dollars that were contributed into the QOF. In that case, the inclusion amount is only 90% of the initially deferred gain (or 70% in the case of a QROF).
3. 10-Year Gain Exclusion- Just as with the OZ 1.0 benefit, any gain recognized on the new OZ investment can be excluded if the taxpayer's interest in the QOF has been held for at least ten years.

Designation of QOZ tracts

As noted above, the OBBBA makes the OZ Program permanent and adopts a decennial designation date (every ten years, commencing July 1, 2026) for designation and certification of QOZ tracts. Certifications become effective on the following January 1st (the first being January 1, 2027) and remain effective for the following ten years. The requirements for qualification of a QOZ tract have been made more stringent. In lieu of 80% (which was relevant in the designation of QOZs for OZ 1.0), the OBBBA sets the “low-income community” threshold at a median family income level of 70% of the statewide or, for metropolitan areas, metropolitan median family income (with a special rule for areas having a 20% poverty rate, and that increases the percentage to 125%). Accordingly, census tracts that currently qualify may no longer qualify under the OBBBA standards.

Ten-year basis step up

Under existing law, the basis step up applies to gains from the sale or exchange of a QOF investment on or prior to December 31, 2047 (30 years from the original date of enactment). The Preamble to the final 2019 QOZ regulations noted the possibility of future guidance to address the potential for an automatic step up in 2047 absent a sale but no formal guidance has yet been published. The OBBBA addresses this issue by providing a full step-up to fair market value at the 30-year mark even if there is not an underlying sale or exchange by such date.

Special benefits for QROFs

A QROF is a QOF that holds 90% of its assets in QOZ property that is located in certain designated rural areas (generally areas other than a city or town with a population greater than 50,000, and any urban contiguous area). There are two additional benefits of a QROF over a regular QOF. First, the historical “substantial improvement” requirement otherwise applicable to QOZ investments (i.e., requiring improvements representing at least 100% of the adjusted tax basis of the property) is reduced to 50% for a QROF. Second, the 10% tax basis step-up generally available for QOF investments after 5 years is increased to a 30% step-up.

Revised reporting requirements

The OBBBA requires comprehensive reporting that must be provided annually by a QOF, beginning in taxable years after the OBBBA enactment (i.e., 2026 for calendar year taxpayers). This reporting includes not only detailed information about the assets and businesses of the QOF, but also information regarding national business codes, residential units, and employees. Failure to satisfy these reporting requirements can result in penalties of up to $50,000 (for QOFs with more than US$10 million of assets) and additional penalties for willful failure to comply. The new reporting requirements will apply to any QOF or QOZB, even those that were formed under OZ 1.0.

Transition

The OBBBA extends and makes permanent the OZ program beyond 2026 with respect to contributions of eligible gain made on or after January 1, 2027. Eligible gains recognized prior to 2027 can still qualify for benefits under the OBBBA so long as the contribution is made after January 1, 2027 and within the applicable 180-day time period. Eligible gains from 2026 that cannot satisfy the 180-day requirement and eligible gains from 2025 can still be contributed to a QOF under existing law and, presumably, with respect to existing QOZ tracts. However, the application of the existing QOZ rules to this transition period, and the application of the rules for each subsequent decennial re-designation of the QOZs, still require clarification.

Authored by Jessica Millett, Jeffrey Uffner, and  Steven Schneider.