Opportunity Zone (OZ) investments already offer attractive tax benefits, stimulating development in distressed communities while bolstering your bottom line. Combine this with a more specialized tax strategy like cost segregation, and the benefits of OZ projects multiply. By accelerating depreciation on eligible property components, this technique can dramatically reduce your current tax burden, all while keeping more cash flowing toward reinvestment or additional OZ acquisitions.
What Are Opportunity Zones?
Opportunity Zones are census tracts struggling with poverty and lack of access to economic opportunities. The Tax Cuts and Jobs Act of 2017 established over 8,700 of these zones across all 50 states, Washington D.C. and some territories. State governors could nominate up to 25% of eligible low-income tracts based on metrics like unemployment rates and median household incomes. The goal was to drive public and private investment into these regions to spark sustainable revitalization.
Tax Benefits
Opportunity Zone tax incentives provide some serious upsides for investors who fund revitalization efforts in overlooked communities. There are three main perks:
- Tax payment deferral: Investors can pause tax payments on existing capital gains if they reroute those gains into qualified Opportunity Zone projects. Rather than losing a portion to taxes upfront, they can defer tax payments until as late as 2026 while their investment accumulates returns.
- Tax discount for long-term commitment: The longer an investor keeps their money invested, the bigger a tax discount they receive. Five years gets you 10% off your tax bill, and seven nets a 15% discount.
- Tax-free growth: Any gains generated directly through a qualified Opportunity Zone investment held for 10+ years face zero capital gains taxes. Invest $100K and cash out at $250K a decade later? That extra $150K can go straight into your pocket.
Aside from the financial benefits, investors reap the reward of knowing they’re doing good for some of the most vulnerable communities in our country.
Qualifying Investments
The investments that qualify for Opportunity Zone tax perks need to deliver tangible economic growth within designated communities. The investments must flow through Opportunity Funds, which are investment vehicles specifically created to funnel capital into businesses, property development and infrastructure located within OZ boundaries.
What Is Cost Segregation?
Cost segregation is a tax strategy that allows commercial property owners to accelerate depreciation deductions on certain building components. Under standard tax rules, commercial buildings are depreciated over a long period of time (often 27.5 or 39 years). A cost segregation study identifies components, like electrical systems, flooring or landscaping, that qualify for shorter depreciation periods (five, seven or 15 years). By depreciating these components more quickly, property owners can reduce their annual taxable income.
Tax Benefits
Cost segregation delivers powerful tax benefits to real estate investors of all types. Investors receive:
- Accelerated depreciation: Cost segregation grants you much faster depreciation on certain components, generating bigger deductions sooner.
- Tax deferral: Deferring taxes keeps cash in your hands for longer. Your money works harder when it's invested, not tied up in the IRS's coffers.
- Increased cash flow: This unlocks potential for refinancing, reinvesting or funding strategic improvements to your properties.
As a note, it’s important to understand that cost segregation isn't about reducing your lifetime tax burden; it's about shifting when you pay taxes to optimize your investment strategies.
Qualifying Investments
Almost all types of commercial and residential rental properties can qualify for cost segregation. This includes:
- Office buildings
- Hotels
- Retail spaces
- Warehouses
- Self-storage facilities
- Gas stations
- Apartment buildings
- Condo complexes
How Cost Seg and OZs Synergize
Opportunity Zones already offer significant tax incentives, but layering cost segregation on top truly maximizes the benefits. The accelerated depreciation provided by cost segregation acts as a powerful growth catalyst within the tax-friendly setting of OZs.
Boosting Cash Flow in Early Years
Cost segregation unlocks a massive acceleration of deductions into the early years of your Opportunity Zone property ownership. This frees up substantial cash flow that you can:
- Reinvest in the OZ project itself, maximizing its success and community impact.
- Fund additional OZ acquisitions to bolster your investment portfolio.
- Use to enhance property functionality and appeal, attracting top-tier tenants.
Maximizing the 10-Year Exclusion
After a decade, OZ regulations exclude capital gains generated by your investment from any taxation. Since cost segregation lowers your property's tax basis, you'll have less basis to recoup upon your eventual sale—meaning even more of your profit enjoys that special OZ tax-free status.
Tackling “Substantial Improvement”
OZ projects require you to improve an existing property by an amount at least equal to its purchase price. A cost segregation study often reduces the building basis dramatically, making this substantial improvement benchmark far easier to attain.
Harnessing Bonus Depreciation
Current tax rules often allow substantial portions of qualified new or used property costs to be depreciated immediately via bonus depreciation. This compounds both cost segregation and OZ benefits to increase your early-year tax savings.
Minimizing Future Tax Liability
Investors in OZ funds face the prospect of a significant tax bill in 2027 related to their deferred capital gains. A cost segregation study provides a powerful tool to reduce this future liability. The accelerated depreciation deductions can dramatically offset the taxable income arising from the OZ investment, easing that tax burden and enhancing overall returns.
How to Unlock the Full Potential of Your OZ Investment
Navigating the regulations and tax strategies involved in both OZs and cost segregation studies requires specialized knowledge. Working closely with a knowledgeable tax advisor and accountant will ensure you make the most of these opportunities while understanding potential risks.
If this powerful combination of tax strategies intrigues you, our experts at ETS can help you explore the potential benefits and implement these strategies on your OZ projects. Reach out today to get started.
