How Investors Can Boost Returns with Opportunity Zones

The qualified opportunity zone (OZ) incentive, enacted as part of the Tax Cuts and Jobs Act, has catalyzed development in many targeted low-income areas throughout the United States. In total, over 8,700 census tracts were designated as qualified opportunity zones (QOZ). When the law was enacted, Congress estimated the program would create $100 billion of new capital investment before the initial investment period expires at the end of 2026.

OZ investors receive three distinct tax benefits:

• Temporary deferral of capital gains invested in a qualified opportunity fund (QOF) through December 31, 2026 (or earlier if the QOF investment is sold)
• 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
• 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

We previously highlighted the looming end of the tax deferral period in a previous blog post, and how stakeholders in the OZ community can begin preparing for the liquidity needs to pay their deferred taxes. If an OZ investment is sold prior to December 31, 2026, the deferred tax liability would be recognized even earlier. Disposing of an OZ investment before December 31, 2026 — or receiving a partial return of capital creating an inclusion event — prevents the investor from obtaining future OZ benefits, most notably the ability to exclude gain after the investment has been held for at least 10 years.

Faced with whether to continue holding a qualifying OZ investment (or whether to defer capital gains before 2026 by making new OZ investments), taxpayers should consider the long-term tax benefits from OZ investments are permanent in nature. The resulting tax savings may produce significant incremental returns and economic value from the underlying investment.

Bipartisan, bicameral support for opportunity zones

The OZ incentive has passed the mid-point of its initial investment period, which under current law is set to end on December 31, 2026. Capital investments into OZ’s slowed during the covid-19 pandemic and continued to remain below pre-pandemic levels as interest rates and inflation have been high. Still, due to the perceived success of OZ by investors and policymakers alike, some in Congress have called for modification, expansion, and extension of the incentive.

In 2023, several bills were introduced which proposed enhancements to the OZ incentive, including investment transparency, reporting, and compliance. Most notably, in September 2023, the House of Representatives reintroduced the Opportunity Zones Transparency, Extension, and Improvement Act. Originally introduced as a bicameral bill in April 2022, several investor-friendly provisions were introduced — including the much-anticipated two-year extension of both the deferral and investment period until December 31, 2028, as well as a new fund-of-funds provision intended to increase the flexibility of structuring OZ investments. The bill also included a significant penalty regime for noncompliance.

“Clear signals are being sent through the proposed bills. Congress wants more transparency from investors and oversight from the IRS,” says Jonathan Ewert, CEO of CapZone Analytics, a tech-enabled compliance provider for the OZ asset class sector.

The 2023 bill retains these and other proposals, but currently it remains only a proposal. Until enacted into law as part of a larger Congressional package, OZ investors must rely only on the legislation and regulatory guidance currently in place.

Depreciation adds significant value to OZ investments

In addition to the tax benefits associated with deferral and exclusion of capital gains — because OZ investments generally focus on investing in tangible property — depreciation deductions may provide significant financial benefits for investors. These benefits, which are permanent in nature, amplify the additional value created by investing in OZ.

While investors should always consult professional advisors about tax and investment strategies, several observations may be made about the tax benefits achieved by investing in OZ. Quantifying an investment's tax benefits and integrating them into that investment's estimated pre-tax financial return profile allows investors to compare the investment's after-tax performance with and without OZ benefits. Understanding and unlocking the permanent tax benefits is how the OZ’s program's full potential can be achieved.

In traditional real estate investments without OZ benefits, annual depreciation deductions may provide a valuable shelter to an investment's cash flow from operations. But because they reduce the underlying property's adjusted tax basis, depreciation deductions are generally recaptured as taxable income or gain when the property is sold and are typically subject to higher tax rates than long-term capital gain income. The effect of this depreciation recapture is taxed at rates ranging from 25% to 37%.

Conversely, OZ investors can eliminate taxable gains after holding an investment for 10 years, including taxes on their investment’s appreciation (increase in value over its original cost), and also taxes associated with depreciation recapture from selling depreciated property. Therefore, an OZ investment may convert depreciation deductions into a permanent tax benefit. The after-tax financial impact of this conversion can be significant. Below is an illustration of how depreciation reduces the adjusted tax basis of property over time — in general, as the property’s basis is written down through annual depreciation deductions.

 

As illustrated above, without OZ tax benefits, past and present depreciation deductions represent future recapture income, causing additional tax liability at a sale, which reduces the investor's estimated net after-tax cash flow. With OZ tax benefits, cumulative depreciation deductions over the life of the investment are not recaptured, creating permanent income tax benefits. This may result in a near zero percent effective tax rate, which means the investor’s total net estimated after-tax cash flow can be equal to or even exceed 100% of every pre-tax dollar earned from the investment — a significant increase in the overall financial returns.

Depreciation deductions are possibly the most significant tool in unlocking the full potential of OZ benefits, and the value of these permanent tax savings may be further amplified through using a cost segregation study. Such studies accelerate depreciation deductions by identifying certain property costs allowed to be depreciated over shorter cost recovery lives. They also may include additional first-year bonus depreciation deductions for eligible property acquired.

Other tax deferral strategies may boost an OZ investment’s after-tax results even further, including:

• Tax benefits for energy efficient property expenditures and tax credits,
• Repair and maintenance studies, and
• Accounting method changes.

How much these mechanisms may enhance after-tax returns is based not only on the underlying performance of the investment, but also on the total time the investment is held.

Opportunity zone after-tax investment examples

Using CLA’s after-tax OZ analysis tools, CapZone Analytics created a fictional investment with market rate assumptions to illustrate the differences in the project’s overall internal rate of return (IRR) and multiple on invested capital (MOIC) when using an OZ investment structure compared to using traditional equity capital without the OZ incentives. The fictional equity investment is $25 million in a multifamily apartment building structured as an OZ investment using 50% leverage which produces an estimated 10% annualized IRR and 2.38x MOIC over 10 years (before income taxes). Federal income taxes have been estimated based on an ordinary income tax rate of 33.4% and a capital gain income tax rate of 23.8%.

 

[Due to variations with state conformity with the OZ program, state income taxes are outside the scope of these illustrations.]

As illustrated above, the same investment made using an OZ structure may be able to achieve a 0% effective tax rate over a 10-year holding period. According to CapZone Analytics, tax benefits from the OZ incentive could boost the investment's after-tax internal rate of return by as much as 50% and increase the investment's after-tax equity multiple by 20%. These incremental returns may create significant value for OZ investors.

Long term opportunity zone investment example

While there are clear incentives associated with holding OZ investments for 10 years (the minimum holding period to achieve the tax-free gain benefit) taxpayers are not required to sell immediately after year 10, and the benefits continue to compound after 10 years. Current regulations allow taxpayers to hold OZ investments until December 31, 2047 (approximately 30 years following the enactment of the Tax Cuts and Jobs Act). Observing how a longer-term investment horizon impacts an OZ investment may provide additional insights for considering OZ investment strategies.

“Depreciation is among the most powerful financial return drivers for real estate investors. In OZ structures, the after-tax returns keep getting better,” observes Ewert.

CapZone Analytics illustrated tax benefits of long-term OZ investments in the following chart, further demonstrating how depreciation may enhance the OZ investment’s overall performance. Over a longer investment period, OZ investments may create even more significant tax savings when compared to traditional non-OZ investments.

 

These illustrations are intended to assess hypothetical scenarios and are based on hypothetical results that may not be realizable. Nevertheless, the importance of analyzing after-tax benefits is highly valuable in illustrating how OZ investments may offer investors a higher net after-tax return compared to non-OZ investments.

How we can help

Investors should consult with professional advisors to determine how OZ investments could benefit their overall tax and financial strategy both before investments are made and during the investment holding period. CLA has a strong team of tax professionals and wealth advisors who have deep experience and working knowledge of opportunity zones, tax planning, and wealth strategies. Contact us for assistance.

Sources of financial illustrations in this article are used with permission from CapZone Analytics, LLC.

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