Extension of the Qualified Opportunity Zone Program with New Updates

The OBBBA extended the availability of deferring capital gains by investing in qualified opportunity zones and included the following key updates:

Deferral Rules

Under the earlier version of the QOZ rules, a taxpayer was able to defer the gain until the earlier of when the investment was sold or Dec 31, 2026. The basis of the original investment is zero. If the qualifying investment was held for at least five years before 12/31/2026, then the taxpayer’s basis is increased by 10% of the original gain that was deferred. If the qualifying investment was held for at least seven years before 12/31/2026, then the basis is increased by an additional 5% of the original deferred gain (for a total of 15%). If the qualifying investment is held for at least 10 years, then the taxpayer can elect to have the basis equal to the FMV on the date that it is sold. This allows all post-acquisition gains to be excluded from income.

Under the new rules, which begin January 1, 2027, the income from the original sale can be deferred until the earlier of five years after the date of investment or the date on which the investment is sold or exchanged. This replaces the single cut-off date of 12/31/26 with a rolling 5-year deferral. After the investment is held for 5 years, the basis is increased by 10% of the original deferred gain (30% for qualified rural properties). If the property is held for more than 10 but less than 30 years, the taxpayer may elect to treat the basis as the fair market value on the date of sale. If an investment is held for 30 years, the taxpayer can elect to treat the fair market value at the 30-year date of the investment as the basis.

Opportunity Zone Designations

Under the new legislation, determinations of QOZ qualification begin on July 1, 2026, and are redetermined every 10 years on July 1.

Under both the earlier and revised versions of the QOZ rules, there is a limit of 25% of the low-income census tracts to be qualified as opportunity zones (with a minimum of 25 eligible tracts per state if the number of low-income communities is less than 100). Under the TCJA, this limit did not apply to Puerto Rico. Under the OBBBA, the 25% limit is applied to Puerto Rico as well.

The eligibility rules for opportunity zones are modified to be somewhat more restrictive. Under the old rules, to qualify as a low-income community, an area had to have either: (1) a poverty rate of at least 20%, or (2) the median family income does not exceed 80% of the state’s median income. The new rules are somewhat more restrictive requiring that the 20% poverty rate test be accompanied by a limit of 125% of the state median income, and the 80% median income test has been lowered to 70% of state median income. Additionally, the new rules remove the ability to qualify under the contiguous census tracts rule.

Introduction of Rural Opportunity Funds

OBBBA added a new category of Qualified Rural Opportunity Fund, which has unique benefits. As mentioned, when the investment is held for at least 5 years, the taxpayer can exclude 10% of the original capital gain income. If the investment was made in rural funds, the taxpayer can exclude 30% of the gain. Additionally, it lowers the substantial improvement threshold to 50% of the adjusted basis. In general, for property to qualify as opportunity zone business property, it must be either original use property to the opportunity zone business or have improvements that exceed the original cost of the property. Under the new rules, rural properties will meet this threshold if they improve the property by 50% of the adjusted basis.

A rural opportunity fund must hold 90% of its assets in qualified opportunity zone business property, which are entirely in rural areas. Rural areas are places with less than 50,000 inhabitants and are not contiguous and adjacent to areas with 50,000 inhabitants.

The substantial improvement requirement made the opportunity zone rules difficult to meet for businesses that are not capital intensive. The lower threshold in rural funds may enable use of the QOZ program among a more diverse group of businesses.

Expanded Reporting and Disclosure Requirements

The OBBBA adds new IRC Section 6039K, which adds additional information to the required annual filings of the QOZ fund on Form 8996. Some of the new information required to be reported includes the number of employees of the business, the number of residential units in the QOZ business property, and details regarding investors who dispose of their interest in the fund during the year. Another new Section 6039L adds a requirement that the qualified opportunity zone business furnish information to the QOZ fund necessary for it to meet the reporting requirements of 6039K.

In addition to the new reporting requirements, the penalties for noncompliance are increased substantially. Under the new rules, a QOZ Fund can be subject to a penalty for non-filing of $500 per day up to a maximum of $10,000 ($50,000 for large QOZ Funds). In the case of intentional disregard, the penalty is $2,500 per day, up to $50,000 ($250,000 for large QOZ Funds).

The following provides a summary of the OBBBA’s changes as compared to the original program enacted by the TCJA.

For more information, please contact Mark Schneider, Partner and Real Estate Tax Leader, or your Anchin Relationship Partner.