Senate Reconciliation Bill Would Make Opportunity Zone Tax Incentive Permanent, Includes Other Significant Changes

Enacted by the 2017 Tax Cuts and Jobs Act, the opportunity zone tax incentive is intended to encourage investments in low-income communities. It does so by allowing taxpayers to defer otherwise taxable capital gain up to the amount such taxpayer invested in such communities, reducing such taxable capital gain by 10% or 15% depending on the year the funds are invested, and excluding from taxable income gain on the appreciation of such investments if held for more than 10 years. The incentive is generally due to expire for new investments made after 2026.

The House version of the bill would have provided a one-time extension to this incentive beyond 2026, but the Senate Finance Committee version would make the incentive permanent.

The following is a more detailed explanation of the proposed changes in the Senate Finance Committee version.

I. Overview of Proposed Changes

• Tightening census tract eligibility. The Senate Finance Committee version of the bill follows the House version tightening the eligibility of census tracts that qualify as opportunity zones to those tracts whose median family income does not exceed 70% of area/statewide median family income (current law requires only 80%), and for tracts with poverty levels of at least 20% by imposing a new cap of 125% of area/statewide median family income. Unlike the House version of the bill, the Senate Finance Committee version does not require any minimum number of rural census tracts to be designated. Tracts that are contiguous to low-income tracts will lose their automatic eligibility and will need to independently qualify to be designated. Puerto Rico will lose its special status, which currently allows it to designate more tracts than other territories and states.

• Designation of new tracts. Under the bill, tracts would be designated every 10 years. First designation will be effective January 1, 2027 (with the designation process beginning in July 2026).

• Deferral of up to 10 years. Gain invested in a qualified opportunity fund (QOF) on or after January 1, 2027, will be eligible for deferral until December 31, 2033. Gain invested on or after January 1, 2034, will be eligible for deferral until December 31, 2043, and so forth with decennial gain recognition dates. The December 31, 2026, gain recognition date will continue to apply to gain invested before that date.

• Spreading the step-up. Gain invested in a QOF on or after January 1, 2026, will benefit from up to 10% discount (by way of a tax basis stepup). Unlike existing rules where the discount is applied only after the investor has held the investment in the QOF for five or seven years, the discount will be applied over the first six years of the investment beginning at 1% at the end of each of the first three years, then 2% at the end of each of the next two years and 3% at the end of the sixth year.

• Special benefits for investments in rural areas. Investments in qualified rural opportunity funds on or after January 1, 2027, would be entitled to a 30% discount instead of the regular 10%, spread over six years using the same schedule but multiplied by three. The substantial improvement test is also relaxed with respect to investments in rural areas, requiring the additional investment to equal only 50% of the cost of the property instead of 100%, and applying this relaxed requirement also to existing projects. A rural area is defined in the bill as any area except a city or town with a population greater than 50,000 and contiguous urbanized areas.

• Changes to the 10-year holding period. Under current law, if an opportunity zone investment is sold before December 31, 2047, an election can be made to exclude gain from such sale (with certain exceptions). The bill would remove the 2047 deadline and provide instead that if the investment is held for more than 30 years, the tax basis of the investment is adjusted to fair market value (and therefore any appreciation until that time is excluded) at the end of the first 30 years. It is yet to be seen if this means that a new depreciation period begins then. It is expected that similar to existing rules, Treasury regulations will also apply the exclusion to dispositions of properties by qualified opportunity zone businesses and not only to dispositions by the investors.

• Reporting Rules. The bill would impose reporting requirements on qualified opportunity funds and qualified opportunity zone businesses, requiring among other things information on the number of residential units and full-time employees. It would also impose penalties for failure to report and require the Treasury Department to prepare certain statistical reports on the program. It remains to be seen whether the congressional Office of the Parliamentarian will require these reporting requirements to be removed from the bill, as was the case in 2017 when it was determined that the reporting requirements are inconsistent with the reconciliation procedures.

• Appropriation. The Internal Revenue Service would be appropriated $15 million to implement the provisions of the bill.

II. Observations

While the bill is an important step to secure the permanency of the opportunity zone incentive, some notable provisions were not included.

• The bill does not include transition rules for existing projects in census tracts that lose their opportunity zone designation in 2027 or at the end of future designation cycles. Such rules are important to allow for a smooth transition toward the end of each opportunity zone designation cycle.

• As we get closer to each gain recognition date, as drafted, the bill would provide an incentive for investors to postpone their investments until after the recognition date has passed to benefit from the new deferral period. This is also the case today for new investments as we get closer to the December 31, 2026, gain recognition date.

• Several important provisions that we were hoping to see in the new bill did not make it. These include giving funds the ability to invest in other funds, allowing interim gain during the 10-year holding period to be reinvested without incurring tax, and including special rules that may be better suited for operating businesses as opposed to real estate investments.