There’s a New Twist on a Capital-Gains Tax Break. How You Get It.

The MLK Gateway development in Anacostia outside Washington, DC. (Menkiti Group / PR Newswire)

A range of investors—including family offices, wealthy folks, and asset managers—who could defer paying taxes on realized capital gains through a federal economic development program—are getting a big policy win.

The federal tax and spending act signed into law earlier this month made permanent a policy that investors could defer capital gains by investing in projects developed in so-called opportunity zones.

Opportunity zones are economically disadvantaged areas selected by state governors and leaders of U.S. territories from a larger group of low-income census tracts for economic development throughout the country. The 2017 Tax Cuts and Jobs Act created the incentive allowing taxpayers to invest capital gains into opportunity zones within 180 days of realizing the gain.

A big advantage: investors aren’t taxed on the growth of the investment if it’s held in an opportunity zone for 10 years or more.

The passage of the policy, now part of the U.S. tax code, is a win for these investors. They can now consider investing in an opportunity zone as “part of their menu of options,” says John Lettieri, president and CEO of the Economic Innovation Group, or EIG, a think tank.

“The goal was to have this be more of a norm,” Lettieri says. The fact it was made permanent is a “testament to the policy” and its impact on economic development, he adds.

Investors flocked to opportunity zone funds, which were created to pool assets for investment, funneling an estimated $100 billion into projects since the 2017 tax act, EIG said in a policy analysis on the new law.

An example is MLK Gateway, a two-phase project in Washington, D.C., to create office space, restaurants, and retail space to serve the Anacostia neighborhood along a strip of vacant storefronts. Another from Sustainable Community Associates in Cleveland, Ohio, used the program to lower rents for 60% of apartments in a building called the Tappan, according to EIG. The financing was directed to residents making between 80% and 120% of the area’s median income.

EIG estimates 313,000 housing units were created nationwide via opportunity zone financing from the third quarter of 2019 to the third quarter of 2024. Other studies have found that opportunity zone investments were often made in areas that were already drawing capital, or would have attracted investment anyway, according to the Brookings Institution.

Quirks in the temporary policy also eroded some of the tax benefits over time. As originally written, if an investment was held for at least five years—before the policy expiration date of Dec. 31, 2026—the cost basis of the realized gains would be stepped up by 10%. The basis would step up another 5% for investments held at least seven years before the expiration date.

The new law simplifies these benefits by providing all investors with a 10% step-up in basis on their original investment after five years. The provision will make it easier to “maintain momentum for local revitalization efforts,” EIG wrote.

Another major change to the law brings more transparency to opportunity zone investments through new reporting requirements. Until now, the U.S. Treasury didn’t officially track assets flowing into these funds or where the capital was deployed. Criticism that the program didn’t support low-income individuals was common.

The Rockefeller Foundation had hoped to leverage the program to drive $1 billion “of private investment to create equitable economic growth and stability for low-wage American workers,” mostly in opportunity zones, for instance. But the foundation found the structure of the program to be flawed, with the primary beneficiaries being “white, high-income investors,” according to a report by the organization.

The new legislation is “a big win for accountability and for a market to form around these investments,” says John Cochrane, director of public policy and special projects at the U.S. Impact Investing Alliance, which has long advocated for more transparency.

“The [reporting] requirements are certainly robust,” Cochrane adds. “It’s maybe not everything impact investors (who invest to realize social and environmental benefits) would have asked for, but it sets a good baseline that will help us and help states understand where money is flowing and what return to the taxpayer investment will be.”

The alliance was behind a voluntary reporting framework created in 2019 that goes beyond the requirements in the new law, but has been adopted by investors and fund managers. Advocates had been pushing for mandatory tracking by the Internal Revenue Service.

“It is hard to imagine how the IRS would investigate potential fraud or abuse of the program without collecting some of this information,” Cochrane says. “At the very least, the IRS will be better informed and better able to establish guardrails going forward.”

The new law also was structured to ensure more investment gets into rural communities. It does this in two ways: first, with a 30% boost in basis for investments held in rural qualified opportunity funds—a new designation; and second, by creating less restrictive requirements for investible projects in these areas.

Typically, to qualify as an opportunity zone investment, a project has to either be new to the area, or it has to double the value of an existing property—not including the value of the land—within 30 months. This latter hurdle ensures investors aren’t making speculative investments that don’t improve or add value to a property, Lettieri says.

To draw investment into distressed rural places, the law now only requires investments in these areas to improve a property’s value by 50%.

EIG estimates that rural areas have received $10 billion in qualifying opportunity zone investments to date—a small percentage of the total, but still a significant figure, he says.

In terms of impact, the new legislation tightens the definition of an eligible census tract by requiring the median family income threshold to be 70% of the statewide or metropolitan area median family income—down from 80%, according to Frost Brown Todd, a national law firm. That means several previous zones will no longer be considered eligible after Dec. 31, 2028, according to the new law.

A taxpayer who wants to invest in an existing opportunity zone has to do it by the end of next year, Frost Brown Todd said.

Previously, census tracts that met the criteria were selected as opportunity zones by governors and executives of such territories as Puerto Rico and Guam, shortly after the 2017 tax act was passed. Under the new law, the selections will be made every 10 years beginning July 1, 2026.

As a result of these changes, the number of qualifying census tracts is likely to go down from the current 8,764.

The lower income requirement will lead to a more targeted program, Cochrane says. “This will make investors think harder about going into areas facing more challenges,” he says. “It will be interesting to see if there is opportunity for investment in this tighter subset of tracks.

Missing from the new law are provisions that would make it easier to invest in operating businesses. One problem with the current law is that an operating business can create an interim capital gain for investors, Cochrane says.

Another issue is that passing the substantive investment test for a given small business project is “prohibitively difficult,” Lettieri says.

Because of these issues, about two thirds of opportunity zone investments are in real estate instead of operating businesses, and critics have argued they don’t do enough to bolster communities. This has been particularly harmful for rural areas, which could greatly benefit from businesses such as logistics, manufacturing, or tourism, he says.

“There is an opportunity and need for future iterations of tax bills to take a crack at some of these issues,” Lettieri says.

Write to Abby Schultz at abby.schultz@barrons.com