Opportunity zone investors face deferred capital gains tax bill

Some high-income investors who defer capital gains taxes through special funds will soon have to pay taxes due.

Authorized by the Tax Cuts and Jobs Act of 2017, Opportunity Zones are economically distressed communities designated by the state and certified by the Department of the Treasury. To encourage investment in so-called qualified opportunity funds, which were created to invest in specific areas, Congress included several tax benefits related to capital gains.

First, investors who stay in a fund for 10 years generally don’t have to pay taxes on the gains they make on their investments. Additionally, investors who deposited capital gains from other investments into the fund could defer paying taxes on those funds. Investors who started investing early enough could also reduce the amount of deferred gains that would ultimately be taxed.

The deferral period ends at the end of this year, but a new report from the Treasury Department’s Office of Tax Analysis shows that these deferred gains totaled $75 billion at the end of 2024.

“Regardless of when an investor defers gains between 2018 and now, the deferral period ends on December 31, 2026, and all gains become taxable from that date,” said Jason Watkins, a partner at accounting firm Novogradac & Company and an expert on opportunity zones.

According to a study by the Ministry of Finance, as of the end of 2024, there were approximately 12,800 eligible opportunity funds in existence, with approximately 41,000 investors participating. The fund can invest in a variety of projects, including new homes, property upgrades, start-up businesses, and other eligible local initiatives.

Approximately 85% of investors are individuals. The rest are businesses, according to the survey. The typical individual investor’s adjusted gross income in 2024 was $738,000.

Capital gains tax is applied to profits from investments that have appreciated in value, and the rate varies depending on how long the investor has owned the asset. If held for more than one year, the gain is considered long-term and is taxed at a rate of 0%, 15%, or 20% depending on the taxpayer’s income. Short-term gains, or gains from investments held for less than one year, are taxed as ordinary income.

Investors who join a qualified opportunity fund before the end of 2019 with realized capital gains can not only defer taxes on those gains until the end of this year (assuming they haven’t already redeemed or become ineligible), but also get a 15% step-up on deferred gains. This means that 85% of the deferred profits will be taxed instead of 100%.

Investors who invested before the end of 2021 are eligible for a 10% basis step-up. Those who miss these deadlines will receive no additional benefits other than deferral of tax on investment gains.

“I hope they plan and realize that they have to pay taxes on these gains,” said Ryan Firth, a certified financial planner and certified public accountant based in Bellaire, Texas. “And hopefully they’ll have money set aside so they can pay their taxes.”

Some funds may have provided liquidity to investors through debt financing or other distributions to cover taxes, Watkins said. Although the benefits of deferring gains are winding down, most investors are likely to stay invested beyond this year because the big reward for investors — tax-free investment gains after 10 years of holding — has not yet occurred, he said.

“We expect very few investors to be willing to take out cash to cover taxes, as achieving a 10-year holding unlocks the most valuable (incentive) and allows for a tax-free exit,” Watkins said.

Some tax benefits will change from 2027.

President Donald Trump’s “Big and Beautiful Act” signed into law last summer made Opportunity Zones permanent. The law calls for new zones to be designated every 10 years, and the next round of nominations is currently underway and is scheduled to take effect on January 1, 2027, according to the Economic Innovation Group, the think tank that originated the idea for these funds.

In exchange for at least one tax benefit being based on the timing of an investment in the Fund, all investors will be entitled to a five-year capital gains deferral, at which point their basis will increase by 10%.

“Having both the five-year deferral and the 10% basis step-up available in perpetuity, regardless of when an investor invests, gives investors more certainty,” Watkins said.

Additionally, there are additional tax benefits for investing in funds focused on rural areas, with these investors able to earn a 30% step-up based on their initial deferred gains after five years, Watkins said.