Cost Segregation and Opportunity Zones

The opportunity zone program was created to encourage long term investment in designated low income communities throughout the United States. State governors nominated census tracts meeting economic distress criteria, and the U.S. Treasury certified approximately 8,700 opportunity zones covering parts of all 50 states, Washington D.C., and U.S. territories.

The program provides three main tax incentives: temporary deferral of capital gains invested in qualified opportunity funds, step up in basis of the deferred gain after certain holding periods (this benefit has now expired for new investments), and permanent exclusion of appreciation on the opportunity zone investment if held for at least 10 years from the investment date.

Key opportunity zone features

• Approximately 8,700 designated census tracts nationwide
• Capital gains from any source can be invested (not limited to real estate)
• 180 day investment window from gain realization
• Gain deferral until December 31, 2026 or sale of QOF interest
• Permanent exclusion of appreciation after 10 year hold

While the basis step up benefits for deferred gains have expired, the core benefit of permanent appreciation exclusion remains extremely valuable. An investor who deploys $1 million in deferred gains into a QOF and holds for 10 years can exclude all appreciation in the opportunity zone investment from taxation, creating substantial wealth building potential.

Qualified opportunity funds are investment vehicles certified to accept capital gains investments and deploy capital in opportunity zones. A QOF can be organized as a corporation or partnership and must be created for the purpose of investing in qualified opportunity zone property.

To maintain QOF status, the fund must hold at least 90% of its assets in qualified opportunity zone property, tested semiannually. This requirement drives QOF investment strategies and affects how quickly funds must deploy capital after receiving investor contributions.

QOFs can be self organized by individual investors for direct investment in specific projects, or investors can participate in pooled funds managed by professional sponsors. Self organized funds provide control but require managing compliance, while pooled funds offer diversification and professional management.

The opportunity zone investment timeline creates a structured progression of benefits tied to holding periods. Understanding this timeline is essential for planning investment strategy and coordinating with other tax benefits like cost segregation.

The timeline begins when an investor realizes a capital gain from any source. Within 180 days of gain realization, the investor must contribute the gain amount to a QOF to qualify for deferral. The QOF then has time to deploy capital into qualified opportunity zone property while maintaining compliance with the 90% asset test.

The permanent exclusion of appreciation after 10 years represents the most valuable benefit. An investment that doubles over 10 years results in complete exclusion of the gain, effectively making the appreciation tax free. Combined with cost segregation reducing taxable income during the holding period, the total tax benefits can be substantial.

Cost segregation provides complementary benefits to opportunity zone treatment by addressing different aspects of tax planning. The opportunity zone structure handles capital gain deferral and exclusion, while cost segregation opportunity zones implementation accelerates depreciation deductions on the property held by the fund.

When a QOF acquires or develops real estate in an opportunity zone, cost segregation can be performed to identify building components eligible for 5, 7, or 15 year recovery periods. This creates accelerated depreciation deductions that reduce the taxable income generated by the property during operations.

The depreciation benefits from cost segregation flow through to QOF investors based on their ownership interests, providing ongoing tax benefits during the holding period. Meanwhile, the opportunity zone structure ensures that appreciation on the investment is excluded from tax after 10 years, creating a powerful combination of current deductions and future exclusion.

For understanding how multiple strategies coordinate, see Stacking Tax Strategies for Maximum Savings which covers comprehensive multi strategy approaches.

For property to qualify as opportunity zone property, it must meet specific requirements related to location, acquisition, and use. These requirements ensure that investments genuinely deploy new capital in designated zones rather than simply refinancing existing investments.

Qualified opportunity zone business property must be tangible property used in a trade or business of the QOF where substantially all of the use is in an opportunity zone. For real estate, this requires either original use commencing with the QOF or substantial improvement during the 30 month period beginning when the property is acquired.

Property qualification requirements

• Acquired after December 31, 2017 from unrelated party
• Original use begins with QOF or substantial improvement made
• Substantially all use is in an opportunity zone during substantially all holding period
• Substantial improvement test met within 30 months if existing property

The substantial improvement requirement is particularly important for existing property acquisitions. The QOF must improve the property by an amount exceeding the acquisition cost basis within 30 months, effectively doubling the basis. This drives many opportunity zone investments toward development and redevelopment projects rather than stabilized acquisitions.

The substantial improvement test requires that additions to basis during the 30 month period equal or exceed the acquisition cost basis of the building (excluding land). This test ensures meaningful new investment in properties rather than passive holding of existing assets.

For example, if a QOF acquires an existing building for $5 million (allocated $1 million to land and $4 million to building), the fund must invest at least $4 million in improvements within 30 months to meet the substantial improvement test. The land value does not factor into the calculation.

Ground up development naturally satisfies substantial improvement because all basis is created through construction. This makes development projects particularly attractive for opportunity zone investment and creates ideal situations for cost segregation because new construction provides maximum component reclassification opportunities.

Properties held by qualified opportunity funds generate operating income during the holding period, and this income is taxable to QOF investors based on their partnership or corporate ownership interests. Cost segregation reduces this taxable income through accelerated depreciation deductions.

The qualified opportunity fund cost segregation benefit operates continuously throughout the holding period. While the investor defers the original capital gain until 2026, any operating income from the opportunity zone investment is taxable currently. Accelerating depreciation through cost segregation reduces or eliminates this taxable income.

At the 10 year mark when the investor exits, the basis step up to fair market value means all appreciation is excluded from tax. The accelerated depreciation claimed during the holding period does not create recapture because the exclusion covers the entire appreciation including amounts previously depreciated. This creates an exceptional outcome where investors receive current depreciation benefits without future recapture.

After holding the QOF investment for 10 years, investors can exit with permanent exclusion of all appreciation. The opportunity zone depreciation rules provide that the basis is stepped up to fair market value at sale, resulting in zero taxable gain on the opportunity zone investment.

The original deferred gain must be recognized in 2026 or when the QOF interest is sold, whichever comes first. For investments made in recent years, the original gain will be recognized in 2026 before the 10 year holding period expires. The investor pays tax on the deferred gain in 2026 but continues to hold the QOF investment and ultimately exits tax free.

Exit strategies include selling the QOF interest after 10 years with basis step up, having the QOF sell underlying properties and distribute proceeds, or continuing to hold beyond 10 years for additional appreciation. The 10 year holding period is a minimum for exclusion, not a maximum holding period requirement.

Opportunity zone investment strategies can be combined with other tax incentives to create comprehensive benefit packages. Properties in opportunity zones may also qualify for energy credits, New Markets Tax Credits in overlap areas, historic rehabilitation credits, or other location based programs.

For projects that qualify for both opportunity zones and NMTC, the combination creates subsidized financing through NMTC alongside capital gain benefits from opportunity zones. This layering can make challenging community development projects financially feasible where either incentive alone would be insufficient.

Energy efficient development in opportunity zones can claim Section 179D or 45L credits alongside opportunity zone benefits and cost segregation. These programs operate independently, each providing distinct benefits that layer to create total value exceeding any single strategy.

For comprehensive guidance on multiple strategy coordination, review Complete Real Estate Tax Planning Guide which addresses end to end planning across all major incentive programs.