Since its launch in 2017, the Opportunity Zone program yielded gains strong enough to propel it into permanence under the One Big Beautiful Bill Act. While the much-discussed “no expiration date” for the program is one of the major changes, OZ 2.0 had its share of other section revisions.
Amendments include new designations and a rural focus, which come paired with enhanced incentives for rural zones, as well as stabilization of gain deferral and stricter reporting and compliance processes.
Current OZ designations will expire at the end of 2026, and a new round will begin in January 2027. Based on current economic data, states will need to re-evaluate OZ designations every decade, starting with July 2026.
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Meanwhile, reporting and compliance have been revised to include detailed annual reporting requirements such as information about the projects, business types and job creation. The Treasury Department is also required to publish annual reports on the program’s impact and efficacy. Significant penalties will apply for non-compliance—generally $500 per day (capped at $10,000 to $50,000), or up to $2,500 per day (capped at $250,000) if violations are intentional.
Short(er)-term effects
For investors who already have capital gains that they are looking to roll into an OZ project, the 5-year deferral of gains, paired with a reduction in the amount of gain subject to tax, will be significant, said David Shapiro, chair & partner of the Saul Ewing tax practice.
“An investor who otherwise would be required to pay tax $1 million of capital gains today (roughly $200,000 in federal tax, assuming long-term capital gains) could invest that $1 million in an OZ project and both defer the gain for 5 years and reduce the taxable amount,” Shapiro continued.
So, assuming tax rates stayed stable instead of paying $200,000 now, that investor would pay $180,000 in 5 years. For QROFs, the tax bill would go down to $140,000 in 5 years’ time. If the investment were made using short-term capital gains, the numbers would look even better, since short-term capital gains would be taxed at ordinary income rates—currently at 37 percent rather than 20 percent.”
Investors who don’t have any capital gains to invest and want the other OZ 2.0 benefits—namely the 10-year exclusion—would have to sell assets and trigger capital gains to get them.
“This is not a change from the prior program, but it is a factor. In my experience, investors are reluctant to sell assets just to get into the OZ program. Similarly, suppose investors were planning to defer real estate gains using 1031 exchanges. In that case, they are reluctant to accept the only temporary deferral of an OZ investment—even with reduced gain recognition—over the indefinite deferral of 1031 exchanges,” Shapiro added.
The 10-year exclusion of capital gains also improves investor yields but requires long-term commitment because any sales prior to the 10-year period end would be fully taxable. “Our experience has been that the value of that exclusion generally translates into a 200- to 400-basis-point increase in the after-tax return from a multifamily project,” shared Steve Friedman, director at CohnReznick Advisory.
OZ 2.0: New rules, new risks
The OZ 2.0 designation requirements are stricter than the old rules. Under the new rules, census tracts adjacent to qualifying tracts can no longer be designated. While the OZ 2.0 tax benefits are designed to help projects in impoverished areas, where ordinary return might not be enough to attract needed capital, the new designations’ tighter income limits could negatively impact market-rate multifamily projects, cautioned Friedman.
The likelihood that there will be fewer projects possible in already gentrified or gentrifying areas, these tax benefits might be necessary to make the project returns economically equivalent to investors, on an after-tax basis, to returns on projects outside opportunity zones, added Shapiro, noting that the gain exclusion does not apply to regular operating income. Meaning that if a project is anticipated to produce rental income materially in excess of expenses, that rental income would be fully taxable.
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The OZ 2.0 rules require significantly more information involving reporting from a Qualified Opportunity Zone Business to a Qualified Opportunity Fund and from a QOF to the Internal Revenue Service. The required information includes the value of the total assets held by the qualified opportunity fund as of each testing date; the population census tracts in which the fund owns property; the amount of investment as of each testing date; the approximate number of residential units for any real property held by the fund; the approximate average monthly number of full-time employees and information on investors, including dispositions of their investment.
OZ 2.0: Long-term after-tax yields
The acceleration of depreciation deductions provides a higher after-tax yield to the investor on the investment but comes with two caveats for multifamily development in an OZ, according to Friedman.
The first caveat generally applies to real estate investment. “Under the passive loss rules first enacted in 1986, a passive investor can only claim current and accumulated losses—like from depreciation—against investments that generate passive income until that passive investment is disposed of in a fully taxable transaction,” he said.
For this purpose, he explained, passive investments do not include portfolio-type investments like dividends or gains from the sale of stocks. “Absent passive income or a taxable disposition of the passive activity, the loss is suspended. That suspension negatively impacts the after-tax return of the investor.”
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The second caveat, continued Friedman, concerns the status of the project as an OZ investment. “Assuming an investor can otherwise claim a loss—like from depreciation—the investor’s ability to claim the loss is limited to the investor’s basis in the QOF, and the investor does not receive basis for the deferred gain contributed to the QOF.”
Typically, this limitation can be overcome by encumbering the project with qualified nonrecourse financing, in which the investors receive additional basis for their respective share of that debt, he advised.
While multifamily projects will not benefit from the special provision allowing expensing of the entire cost of construction of certain manufacturing buildings, there still are significant benefits to cost segregation and full expensing of all assets that can be segregated from the building itself, concluded Shapiro.
OZ 2.0: Fitting in with other tax incentives
OZ 2.0 represents the best tax-advantaged program available to investors, according to Liam Krahe, fund manager of QOZ Fund I. He explained it’s because it allows individuals or entities to defer the tax on the sale of essentially all assets, including real estate, stocks, bonds and crypto, unlike 1031 and 721 exchanges, which are limited to the sale or transfer of real estate.
Owen Caine, AVP, Federal Legislative Affairs at the NAA, further explained that, unlike the Low-Income Housing Tax Credit, OZs are not solely focused on increasing housing supply and act as a magnet for capital in areas that need it, which provides more opportunities for investments in affordable housing through LIHTC or other means.
“The missions of the two incentives are different, but they can be used in tandem to reach positive outcomes. In short, OZs are another unique tool in the toolbox to address the nation’s housing affordability challenges,” he said.
While the OZ 2.0 changes generally are very positive and the ability to stack the OZ benefits with other federal, state and local incentives is very powerful, one possible “miss” in the enhanced OZ 2.0 rules is the failure to extend the tax trigger date of December 31, 2026. “The failure to adopt that extension may exacerbate the capital shortfall current projects are facing,” observed Friedman.
OZ 2.0 and the rise of rural investment
The new version of the program comes with significant economic incentives to invest in rural projects. While for general QOF investments deferred gains are reduced by 10 percent, the figure for rural projects is threefold, up to a hefty 30 percent. What’s more, at least 25 percent of all designated Opportunity Zones in each state or territory must be rural, according to Shapiro.
Largely, for $1 million of capital gains invested in an OZ project, only $900,000 would be taxable in 5 years, pointed out Shapiro. For a rural project, a $1 million investment would result in $700,000 taxable in 5 years. “That’s significant additional savings, especially if the deferred gains were short-term capital gains that otherwise would be taxable at ordinary income rates,” he said.
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The Act also restores some bonus depreciation, which is a potential benefit in both QOFs and RQOFs (rural QOFs), depending on their personal tax situations. Moreover, the Act does not change the ability of QOFs and RQOFs to “stack” tax benefits— that is, the ability to use a single project to qualify for various federal and state incentive programs, noted Friedman. “An affordable housing project may be able to qualify for OZ benefits, LIHTCs and state tax incentives like property tax abatements,” he added.
Furthermore, investments in Qualified Rural Opportunity Funds (QROFs) will also benefit from a relaxed “substantial improvement” test for existing property rehabilitation, according to Caine.
OZ 2.0: From stress test to trigger point
From an investor perspective, the Opportunity Zone incentives can take a project with good projected returns and make it great or take a project with a decent projection and make it good, according to Shapiro. However, he cautioned, these incentives will not take a bad project and make it great.
“The first step is to stress test the project economics without regard to the tax benefits. Once that is done, an investor should be sure that there are protections to ensure that the sponsor will hold and manage the project through the full 10-year gain deferral period so that the investor gets the full Opportunity Zone benefits, or at least that the investors have consent rights if economic conditions or opportunities dictate that a project be sold,” he said.
The deemed sale trigger at the end of 2026 in OZ 1.0 is likely to tempt many investors to remain on the sidelines until the enhanced benefits of OZ 2.0 become effective. Friedman shared that existing projects already experience a challenging equity capital environment as investors hit the pause button.
“This may cause sponsors of existing projects to evolve into a ‘mixed fund’ approach as they seek preferred equity to complete the capital stack of these existing projects,” Friedman estimated.
The deemed sale trigger raises another near-term consideration, subjecting to tax the lesser of the original deferred gain or the fair market value of the investment on that date. “The determination of that FMV amount will likely require thoughtful consideration,” he advised.
The impact of the OZ 2.0 program has a host of variables. Typical of real estate, the main ones are related to location: Projects located in higher-income census tracts currently designated as Opportunity Zones will be pressured to fund them before the end of 2026, when those designations will terminate. Meanwhile, for projects in census tracts that are likely to be designated as Opportunity Zones in the new round of designations, capital might stay on the sidelines until 2027, when the new gain deferral and reduction benefits come into effect.
“The fundamental investment thesis behind the OZ program is an investor’s ability to generate capital or section 1231 gains, which form the basis of the investment. So long as investors can continue to generate those gains, the program will have a ready source of investment capital. Conversely, if those gains become more challenging, the universe of interested investors may wane,” said Friedman.
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