The Opportunity Zones program is designed to incentivize patient capital investments in low-income communities nationwide. All of the underlying incentives relate to the tax treatment of capital gains, and all are tied to the longevity of an investor’s stake in a qualified Opportunity Fund, providing the most upside to those who hold their investment for 10 years or more.
Opportunity Zones allow investors to defer capital gains taxes
Investments made by qualified entities known as Opportunity Funds into certified Opportunity Zones will receive three key federal tax incentives to encourage investment in low-income communities.
The figure above and the table below illustrates how an investor’s available after-tax funds compare under different scenarios, assuming various holding periods, annual investment appreciation of 7%, and a long-term capital gains tax rate of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%). For example, after 10 years an investor will see an additional $44 for every $100 of capital
gains reinvested into an Opportunity Fund in 2018 compared to an equivalent investment in a more traditional stock portfolio generating the same annual appreciation. Table 1 and the examples that follow provide additional information on the tax liabilities and differences in the after-tax annual rates of return.
Table 1
How Investing in an Opportunity Fund Compares to a Traditional Stock Portfolio
Scenario: A Capital Gain of $100 is Reinvested in 2018
Example 1
Lilah has $100 of unrealized capital gains in her stock portfolio. She decides in 2018 to reinvest those gains into the OZ Opportunity Fund that invests in distressed areas of her home state, and she holds that investment for 10 years. Lilah is able to defer the tax she owes on her original $100 of capital gains until 2026. Further, the basis is increased by 15% (effectively reducing her $100 of taxable capital gains to $85). Thus, she will owe $20 (23.8% of $85) of tax on her original capital gains when the bill finally comes due. In addition, since she holds her OZ Opportunity Fund investment for at least 10 years, she owes no capital gains tax on its appreciation. Assuming that her OZ Opportunity Fund investment grows 7% annually, the after-tax value of her original $100 investment in 2028 is $176. Lilah has enjoyed a 5.8% effective annual return, compared to the 2.8% an equivalent non-OZ Opportunity Fund investment would have delivered. Total tax bill in 2028: $20
- After-tax value of investment in 2028: $176
- Effective after-tax annual return on $100 capital gain in 2018: 5.8%
- Total tax bill in 2025: $35
- After-tax value of investment in 2025: $126
- Effective after-tax annual return on $100 capital gain in 2018: 3.3%
Example 2
As in Example 1, in 2018 Lilah rolls over $100 of capital gains into the OZ Opportunity Fund. She holds the investment for 7 years, selling in 2025. As in Example 1, she temporarily defers the tax she owes on her original capital gains and steps-up her basis by 15 %, so that in 2025 she will owe $20 (23.8% of $85) of tax on her original capital gains. Unlike Example 1, however, Lilah will owe capital gains tax on the appreciation of her OZ Opportunity Fund investment, since she holds the investment for less than 10 years. Assuming that her OZ Opportunity Fund investment grows 7% annually, in 2025 Lilah will owe $15 (23.8% of $61) of tax on the OZ Opportunity Fund investment’s capital gain. Lilah did not take full advantage of the Opportunity Zone program but nevertheless received a 3.3% effective annual return compared to the 1.5% an equivalent non-OZ Opportunity Fund investment would have delivered.
Total tax bill in 2025: $35
After-tax value of investment in 2025: $126
Effective after-tax annual return on $100 capital gain in 2018: 3.3%
Example 3
As in Example 1, in 2018 Lilah rolls over $100 of capital gains into the OZ Opportunity Fund. She holds the investment for 5 years, selling in 2023. As in Example 1, she can temporarily defer the tax she owes on her original capital gains, but her step-up in basis is only 10%, so that in 2023 she will owe $21 (23.8% of $90) of tax on her original capital gains. As in Example 2, Lilah enjoys no exemption from capital gains tax on the appreciation of her OZ Opportunity Fund investment, since she holds the investment for less than 10 years. Assuming that her OZ Opportunity Fund investment grows 7% annually, in 2023 Lilah will owe $10 (23.8% of $40) of tax on the OZ Opportunity Fund investment’s capital gain. Lilah did not take full advantage of the Opportunity Zone program but nevertheless received a 1.8% effective annual return on her initial capital gains compared to the -0.1% effective annual return an equivalent non-OZ Opportunity Fund investment would have delivered.
Total tax bill in 2023: $31
- After-tax value of investment in 2023: $109
- Effective after-tax annual return on $100 capital gain in 2018: 1.8
Information provided by Economic Innovation Group, a bipartisan public policy organization, combining innovative research and data-driven advocacy to address America’s most pressing economic challenges
