Return to OZ – Opportunity Zones in the OBBBA

“Thank you, and on behalf of the group and ourselves I hope we passed the audition.”  So said John Lennon after the Beatles’ farewell rooftop concert.  And so (figuratively) said the Opportunity Zone (OZ) program, which became law in 2017 and was due to sunset in 2026.  The recently passed One Big Beautiful Bill Act (OBBBA) has answered with a resounding “yes”— the Opportunity Zone program has passed its audition and has now been made a permanent tax law fixture.

The original Opportunity Zone provisions are a novel part of the 2017 Tax Cuts and Jobs Act (TCJA). Under those provisions an investor can defer capital gain recognition by investing the capital gain in a Qualified Opportunity Fund (QOF), which in turn acquires or “substantially improves” property located in a Qualified Opportunity Zone (QOZ), either directly or indirectly by owning an interest in a Qualified Opportunity Zone Business (QOZB) which owns the property.

Under the current OZ provisions from the TCJA, “Opportunity Zones” are census tracts that meet certain eligibility criteria and are selected by the governor of each state.  All deferred gains are recognized by investors and taxed on December 31, 2026.  An investor’s basis in their QOF investment is zero, but the investor’s basis is stepped up by 10% if the investment is held for five years, and another 5% if held for seven years.  If the investment is held for 10 years, all gain realized following the initial investment is permanently excluded.

The OBBBA does not grant an extension to the current OZ program—the gain previously deferred under that program must still be recognized on December 31, 2026.  Instead, the OBBBA uses the existing OZ provisions to create a new, permanent program beginning on January 1, 2027, with the following changes to the existing OZ provisions.

Rolling Gain Deferral.

For OZ investments made on or after January 1, 2027, deferred gain is recognized upon the earlier of: (i) the sale or exchange of the QOF investment, or (ii) five years following the date of the investment.  Investments held for the full five years receive a step-up in basis of 10%, so only 90% of the deferred gain is actually taxed if held for five years.  The other basis step-ups under the TCJA provisions have been repealed.

Changes to the 10-year Gain Exclusion.

The OBBBA retains the exclusion of capital gains for investments held for 10 years by providing a step-up in basis to fair market value for sales after 10 years.  However, the capital gain exclusion is capped at 30 years.  If the investment is held for 30 years, the investor’s basis is stepped-up to fair market value at that time, and is set at that amount going forward.

New “Qualified Rural Opportunity Fund.”

As an incentive to invest in rural areas, the OBBBA creates a new class of QOF: the “Qualified Rural Opportunity Fund” (QROF) which provides investors with enhanced tax benefits. A QROF operates the same as a QOF, except the Qualified Opportunity Zone Business Property (QOZBP) held by the QOF (or the QOZB) must be located in a “rural area,” which is defined as “any area other than (I) a city or town that has a population of greater than 50,000 inhabitants, and (II) any urbanized area contiguous and adjacent to a city or town described in clause (I).”

For an investment in a QROF, an investor will receive a 30% basis increase if held for the full five-year period (as opposed to the 10% increase for regular QOFs described above). Additionally, the “substantial improvement” requirement is reduced to 50% of adjusted basis, as opposed to 100%, making it easier for renovations in rural areas to qualify.

New Provisions for Designating Qualified Opportunity Zones

The OBBBA creates a decennial selection process for QOZs.  The first round of new QOZs will be identified by July 1, 2026, with such zones becoming effective on January 1, 2027.  A new round of QOZs will be selected every 10 years thereafter.

In selecting such QOZs going forward, more restrictive requirements will apply, including: (i) census tracts will qualify as QOZs only where median family income does not exceed 70% of the metropolitan area median family income (rather than the current 80% standard); (ii) the alternative poverty rate test of 20% or more is modified to include an “anti-gentrification” trigger that disqualifies a census tract if the median family income is over 125% of the applicable state or metropolitan area median family income; (iii) the contiguous tract rule that qualified census tracts contiguous to a “low-income community” has been repealed; and (iv) the general QOZ designation for all low-income communities in Puerto Rico has also been repealed.

New Reporting Requirements

In response to criticisms that the OZ program lacks transparency regarding its actual benefits for local communities, the OBBBA creates a new reporting regime for QOFs (and QROFs) and QOZBs.  Under the new regime, QOZBs are required to prepare and furnish a report to the QOF, with the QOF then preparing a report to be delivered to investors and filed with the IRS.

Information that must be reported by the QOF to the IRS includes: (i) the North American Industry Classification System code for the QOF’s trades or businesses; (ii) the population census tract(s) in which the QOZBP is located; (iii) the aggregate value of owned and leased tangible property of the QOF; (iv) the number of residential units held by the QOF; and (v) the average monthly number of full-time employees.

To enforce compliance, the OBBBA introduces significant penalties for failing to comply with the new reporting requirements. A QOF that fails to file complete and accurate reports can face daily fines, with higher limits applied to large funds. The OBBBA mandates that reports be filed electronically for easier aggregation and analysis.  The OBBBA also tasks the Treasury Department with producing extensive public reports on the OZ program’s effectiveness.