Does my depreciation recapture get eliminated?
In addition to the benefits of tax deferral (until Dec. 31, 2026) and tax exemption on appreciation of the capital gain investment (if investment is held for at least 10 years), the third benefit of investing in a QOZ is that depreciation recapture is excluded from U.S. federal income tax.
A tax-free depreciation recapture allows taxpayers to generate revenues offset by depreciation during the 10 years the investment is held. Typically, this depreciation reduces tax basis by the equivalent amount and, at the time of a future sale, tax is applied recapturing the depreciation at ordinary income or capital gains rates.
Under Opportunity Zone provisions, however, the depreciation recapture and any appreciation in the asset is not subject to tax. For example, if an investor invests $100 into an asset that depreciates evenly over a 10-year period, that investor would be able to offset $10 of otherwise taxable income with $10 of depreciation deduction for 10 years. At the end of the 10-year period, the investor would have a tax basis of $0 in the asset. Thus, if the investor sold the asset for $200, the investor would recognize a gain of $200, which would be subject to tax at ordinary income rates or long-term capital gains rates, as the case may be. That same investment within a Qualified Opportunity Fund (QOF) could be sold tax-free from a U.S. federal income tax perspective, which would exclude tax on both the depreciation recapture and the appreciation in the asset’s value.
An investment in a QOF also provides investors the opportunity to refinance the investment and take a distribution of the refinancing without being subject to immediate U.S. federal tax liability. For example, in year one an investor invests $100 into a QOF. Those amounts are appropriately invested by the fund. In year three, a bank provides the QOF a loan for $50, which is immediately distributed by the fund to the investor. The investor can use those funds for whatever purpose they choose. Properly structured, the distribution of the proceeds generally should not trigger a U.S. federal tax liability to the investor.