Making room for TBED in new Opportunity Zones

The Opportunity Zone (OZ) program, first established in 2017 with a ten-year lifespan, has been made permanent in Public Law No: 119-21. As noted in a July 10 Digest article recapping the reconciliation package, OZ has undergone significant revisions. Some of the changes may address criticisms raised with the program design, also covered in the Digest, here, here, and here. The newly enacted revisions include updates to zone eligibility, rural incentives, and reporting requirements that preserve the program design, yet add significant changes that will impact how the program functions moving forward. 

The Opportunity Zone program is, at its core, an incentive to drive private investment to low-income communities by deferring and reducing capital gains taxes on investments made in selected census tracts. To benefit from the program, investors must invest through Qualified Opportunity Funds (QOFs) using the proceeds from prior investments. The QOF then invests in businesses located in Opportunity Zones. Investors are able to defer and reduce capital gains tax on the initial investment by rolling it into a QOF. Subsequently, investors can eliminate capital gains tax on proceeds from investments in Opportunity Zone businesses held for ten years or more. 

Unlike many other programs intended to spur development in low-income neighborhoods, the Opportunity Zone program does not require initial approval or registration of the business or investments to qualify, though the taxpayer must keep sufficient records to demonstrate eligibility. Even without an application process, the program has the expected complexity of a tax incentive geared toward investments: interested parties are encouraged to consult with qualified tax professionals to understand the mechanics of the program and the potential benefits for their companies. 

This Digest article focuses on the changes to the program most likely to impact economic development efforts. 

One of the major changes is to eligibility criteria for census tracts. The definition of a low-income community will shift from using New Market Tax Credits criteria to a narrower definition more closely tied to lower income levels. Under the new criteria, the median income of eligible census tracts will drop from 80% to 70% of either statewide or metro area income depending on a zone’s metropolitan status. Tracts can also be eligible if they have at least 20% poverty rates, and the median family income does not exceed 125% of applicable state or metro area income. The statute eliminates the previous option to designate tracts that do not meet eligibility criteria on their own but are contiguous with eligible tracts and do not exceed 125% of area median income. A detailed analysis by the Economic Innovation Group estimates that there will be approximately 20% fewer zones eligible under the updated criteria .

There is a change unique to Puerto Rico that removes the special designation of all low-income census tracts as Qualified Opportunity Zones. Puerto Rico will now need to nominate 25% of eligible tracts. 

Existing zones will expire at their 10-year maturation; the updated eligibility criteria will require new zones to be nominated every ten years. The first new round of nominations is due before July 1, 2026, and will be effective for investments made after December 31, 2026. The program preserves the process of state governors nominating up to 25% of eligible census tracts. The next round of designations will need to incorporate state and local priorities and economic changes since 2017. 

Adjacent tracts to designated zones are no longer eligible for the tax advantages of the program. This change, the constrained eligibility, and an increased incentive for rural investments, are likely to shape state and local conversations around designations over the next year. 

The investment incentives remain conceptually the same, with investors able to defer and reduce capital gains tax on eligible investment in Qualified Opportunity Funds (QOF) that invest in Opportunity Zone businesses. There are, however, some changes to the incentive that will impact investors. The capital gain tax deferral and reduction of initial QOF investments is capped at a 10% basis adjustment with a five-year holding period. The seven-year holding period and 15% basis adjustment is eliminated. The ongoing nature of the program also allows for a rolling holding period for capital gains deferrals rather than an established "day of reconning” in the first version of the program. The 100% step up in basis cost and effective elimination of capital gains tax on the proceeds of QOF investments held for at least ten years are preserved from the original program. The ongoing increase in basis cost for QOF investments held more than 30 years is eliminated and is now set at year 30 instead of when it is eventually sold. 

One of the most significant changes is the enhanced criteria and investment incentives for investments in rural opportunity zones through Qualified Rural Opportunity Funds. Rural designation applies to low-income communities that are cities or towns with fewer than 50,000 inhabitants not connected to a city or town with more than 50,000 inhabitants. The benefit of investing in rural communities is a 30% basis cost adjustment for initial investments held for five years compared to 10% for non-rural communities. Another parameter linked to rural investments is the requirement that properties be improved by 50% from the prior 100% that is still linked to low-income communities. 

Beyond the eligibility criteria and increase in benefit for rural investments, the other major changes concern reporting requirements. Investors will be required to report information on industry, employees, residential units, and various financial measures of businesses and funds when filing their taxes. Much like economic development reporting requirements, investors will need to ensure that their investment agreements require downstream businesses to provide the data needed to meet filing requirements. The reporting changes should allow for additional insight into investment activity and impact on low-income communities with public reports published annually and a more robust analysis every five years. 

For the economic development community, practitioners should prepare for increased conversations around zone selection, and, from a TBED perspective, add an eye toward prioritizing OZ locations that allow regions to exploit or grow their innovation assets. 

With private markets having experienced the potential benefits of the program, it is reasonable to expect more widespread interest in zone selection than the first round of designations. This increased interest, coupled with the limited number of zones available, will require governors to carefully balance multiple criteria in selecting zones that can meet both policy goals and perform in current market conditions. 

With Opportunity Zones being fundamentally a location-based program, the development opportunities within zones will depend on local market nuances. TBED professionals may want to track potential zone eligibility within their service area and identify if there are opportunities to support the development of zones and funds targeted to tech-based investments. 

This page was prepared by SSTI using Federal funds under award ED22HDQ3070129 from the Economic Development Administration, U.S. Department of Commerce. The statements, findings, conclusions, and recommendations are those of the author(s) and do not necessarily reflect the views of the Economic Development Administration or the U.S. Department of Commerce.