The 2017 tax revision (P.L. 115-97) temporarily authorized Opportunity Zone (OZ) tax incentives, which are intended to encourage private investment in economically distressed communities.¹ In 2018, the Community Development Financial Institutions (CDFI) Fund in the Treasury Department designated qualified census tracts that are eligible for OZ tax incentives after receiving recommendations from a state's chief executive officer (CEO), generally the governor. Qualified OZ designations are in effect through the end of 2026.

Investments eligible for OZ tax incentives must be channeled through a qualified opportunity fund (QOF). The tax benefits for these QOF investments include (1) a temporary tax deferral for capital gains reinvested in a QOF, (2) a step-up in basis for any investment in a QOF held for at least five years (10% basis increase) or seven years (15% basis increase), and (3) a permanent exclusion of capital gains from the sale or exchange of an investment in a QOF held for at least 10 years. These incentives effectively increase the after-tax rate of return of QOF investments to their investors.

This report describes what census tracts have been designated as an OZ, what types of entities are eligible as QOFs, the tax benefits of investments in QOFs, what economic effects can be expected from OZ tax incentives, and several issues for Congress regarding the implementation and oversight of OZ tax incentives.

For further reading on the CDFI Fund's other programs and analysis of related policy issues, see CRS Report R42770, Community Development Financial Institutions (CDFI) Fund: Programs and Policy Issues. (Throughout this report, the CDFI Fund is referred to simply as "the Fund".) For updated guidance regarding OZ tax incentives, see websites created by the Fund and Internal Revenue Service (IRS).²

Opportunity Zone Designations

Opportunity Zones were nominated by states' CEOs (e.g., governors) in early 2018. Specifically, states' CEOs nominated, in writing, a limited number of census tracts to the Secretary of the Treasury to be designated eligible for OZ tax incentives.³ These nominations were due by March 21, 2018.⁴ A nominated tract must have been either (1) a qualified low-income community (LIC), using the same criteria as eligibility under the New Markets Tax Credit (NMTC),⁵ or (2) a census tract that was contiguous with a nominated LIC if the median family income of the tract did not exceed 125% of that contiguous, nominated LIC.⁶ In principle, these requirements appear to have been intended to provide governors with the ability to identify LICs, or low- to moderate-income areas adjacent to LICs, in which to direct OZ tax benefits.⁷

P.L. 115-97 explicitly limits the number of census tracts within a state that can be designated as qualified OZs based on the following criteria:

• If the number of LICs in a state is less than 100, then a total of 25 census tracts may be designated as qualified OZs.
• If the number of LICs in a state is 100 or more, then the maximum number of census tracts that may be designated as qualified OZs is equal to 25% of the total number of LICs.
• Not more than 5% of the census tracts designated as qualified OZs in a state can be non-LIC tracts that are contiguous to nominated LICs. This effectively limits the number of census tracts that are not economically distressed or low income from receiving the OZ designation.

The official list of designated Opportunity Zones was published in IRS Notice 2018-48 and IRS Notice 2019-42.

Qualified Opportunity Funds

P.L. 115-97 defined a QOF as any investment vehicle organized as a corporation or partnership for the purpose of investing in a qualified opportunity zone property (other than another QOF) and which holds at least 90% of its assets in qualified OZ property. A qualified OZ property can be a stock or partnership interest in a business located within a qualified OZ or tangible business property located in a qualified OZ. Examples of potential QOF investments in qualified OZ property include purchasing a building located in a qualified OZ, purchasing stock in a business located in a qualified OZ, or purchasing machinery used by a business located in a qualified OZ.

A qualified OZ property must have been acquired by the QOF after December 31, 2017. For each month that a QOF fails to meet the 90% requirement it must generally pay a penalty. The penalty is calculated based on the monthly shortage multiplied by an underpayment rate (short-term federal interest rate plus three percentage points).

The IRS instructs a corporation or partnership seeking to become a QOF to self-certify its status by filling out Form 8996 as part of its annual income tax filings.⁸ (This self-certification process differs from the NMTC, in which the Fund takes prospective action to certify "community development entities" (CDEs) before they can receive an NMTC allocation.)

Tax Benefits for Qualified OZ Investments

P.L. 115-97 provides three main tax incentives to encourage investment in qualified OZs. These benefits are briefly summarized, followed by an illustrative example showing how the three benefits reduce the amount of capital gains subject to taxation for OZ investors:

• 1. Temporary deferral of capital gains that are reinvested in qualified OZ property: Taxpayers can defer capital gains tax due upon the sale or disposition of a (presumably non-OZ) asset if the capital gain portion is reinvested within 180 days in a QOF.⁹ Under current law, the deferral of gain is available on qualified investments up until the earlier of (a) the date on which the investment in the QOF is sold or exchanged, or (b) December 31, 2026.¹⁰
  
  In other words, this deferral is only in effect until December 31, 2026. Any reinvested capital gains in a QOF made before this date must be realized on December 31, 2026. Thus, investors would realize the deferred gain in their 2026 income filings, even if they do not sell or dispose of their investment in a QOF. Any reinvested capital gains in a QOF after this date are not eligible for deferral.
• 2. Step-up in basis for investments held in QOFs: If the investment in the QOF is held by the taxpayer for at least five years, the basis on the original gain is increased by 10% of the original gain. Basis is generally the value of capital gain when the investment is sold, before it is reinvested in a QOF.¹¹ (An increase in basis, all else unchanged, reduces the amount of the investment subject to taxation and hence reduces tax liability.) If the OZ asset or investment is held by the taxpayer for at least seven years, the basis on the original gain is increased by an additional 5% of the original gain.
• 3. Exclusion of capital gains tax on qualified OZ investment returns held for at least 10 years: The basis of investments maintained (a) for at least 10 years and (b) until at least December 31, 2026, will be eligible to be marked up to the fair market value of such investment on the date the investment is sold. Effectively, this amounts to an exclusion of capital gains tax on any gains earned from the investment in the QOF (over 10 years) when the investment is sold or disposed.

Table 1 illustrates the tax benefits of a hypothetical investment of $100,000 in a QOF made in 2019. This investment could be $100,000 in capital gains earned from the sale or disposition of another asset (e.g., real property) from outside an OZ that is reinvested into a QOF within 180 days from the date of that sale or disposition. Taxes on these capital gains are deferred while the investment is held in a QOF. As investments made after 2021 no longer qualify for either the 10% or 15% basis adjustments, investments made in 2022 or later would be eligible for a smaller incentive than shown in Table 1.

Column A shows the investment's value over time, assuming a 7% annually compounded rate of return. This hypothetical investment is simplified to assume that an initial investment in a QOF is made in year one and the QOF constantly reinvests any returns to that initial investment (i.e., the QOF does not pay out periodic dividends to the investor during the life of the investment).

Column B shows the increase in adjusted basis earned from holding that investment in a QOF over time: 10% of the original capital gain of $100,000 after the investment is held in a QOF for at least five years (10% of $100,000 = $10,000), and 15% after the capital gain is held for at least seven years (15% of $100,000=$15,000).

Column C shows the mandatory recognition of reinvested capital gains at the end of 2026.¹² Even if the investor retains their investment in the QOF beyond 2026, they must still recognize or pay capital gains tax on $85,000 in capital gains under this hypothetical example. This adjustment amount is calculated as $100,000 in capital gains initially rolled over into the QOF in 2019 (i.e., tax deferred) minus the $15,000 in basis adjustment for holding their investment in the QOF for seven years.

Column D shows the amount of capital gains subject to taxation if the investment in a QOF is sold or disposed of in any of the 10 years shown in the table. Of note, if the investment was sold after being held for 10 years, then any capital gains earned on the initially reinvested $100,000 would be completely excluded from tax. In the hypothetical example, the investor earned an additional $96,715 from their initial investment of $100,000. Therefore, if they held that QOF investment for 10 years and then sold it, they would not pay tax on the $96,715 in gains as well as not paying tax on $15,000 worth of the original investment. (They would have realized $85,000 in capital gains in 2026, and paid capital gains tax on that amount.) In other words, for their investment valued at $196,715 in 2029, the investor would have paid tax on $85,000 of this amount in 2026, with the remainder being tax-free. This calculation illustrates that a major economic incentive to investing in a QOF is the permanent exclusion of capital gains earned after the acquisition of the QOF investment.¹³

Note that Table 1 only shows the tax-related benefits of investing in a QOF. It does not include the economic benefits of temporarily deferring capital gains tax on the initial $100,000 investment, which would depend on the time value of money, which is the economic concept that an amount of money available at the present time is generally worth more than the same amount in the future. Accordingly, investors would prefer to defer paying tax because the money they would use to otherwise pay the tax could be put to some other use with a higher rate of return (e.g., investing in other assets) while their tax bill is deferred. From an income tax collection perspective, though, deferral of capital gains tax just delays a tax liability from one period to another.

Actual QOF investment structures could differ from the arrangement in Table 1. With a similar tax benefit, the New Markets Tax Credit (NMTC), investors have developed financial structures that increase the amount of other funding from private or public sources (i.e., increasing leverage on the NMTC investment).¹⁴ Additional layers of financing structures could increase the complexity of investment arrangements and costs attributed to fees and transactional costs instead of development, which could ultimately reduce investment in development projects, all else being equal.¹⁵

OZ tax incentives are in effect from the enactment of P.L. 115-97 on December 22, 2017, through December 31, 2026. There is no gain or deferral available with respect to any sale or exchange made after December 31, 2026, and there is no exclusion available for investments in qualified OZs made after December 31, 2026.

Implementing Regulations

The Department of the Treasury and IRS issued multiple sets of proposed regulations related to investments in a QOF (under Section 1400Z-2). Notices of Proposed Rulemaking (NPRM) were published in the Federal Register on October 29, 2018, and May 1, 2019.¹⁶ The final regulations were published in the Federal Register on January 13, 2020.¹⁷ These regulations inform investors, QOFs, and other parties that have invested in or are considering investing in projects located within qualified OZs. A comprehensive analysis of the lengthy, final regulations is outside the scope of this report.¹⁸

With that said, commentators have noted that the final regulations provide guidance on a range of transactional matters, such as what types of capital gains may be invested, what qualifies as qualified OZ business property, when QOF transactions trigger or do not trigger recognition of capital gain, when capital gains qualify for the purposes of the 10-year exclusion, and other exit considerations for investors.¹⁹ Some of these positions are consistent with those established in the regulations proposed in 2018 and 2019, whereas other positions in the final regulations represent a change from the proposed regulations.

The final regulations became officially effective on March 13, 2020, but commentators and practitioners have noted that they appear to have mixed guidance for retroactive application. The preamble of the final regulations notes that taxpayers may choose to either rely on the final regulations or the proposed regulations, as long as they pick one or the other consistently.²⁰ Individual sections of the final regulations, though, appear to allow a taxpayer to apply either the final or a proposed version of the regulations on a section-by-section basis.²¹ IRS and Treasury could clarify this issue in subsequent guidance.

Expected Economic Effects of OZs

Because OZs are a relatively new tax benefit, there are limited data that can be used to assess their specific impacts on economic development. Nonetheless, economic theory and examination of several other geographically targeted federal programs and incentives for economic development may provide insights on the expected economic effects of OZs. Examples of similar economic development incentives that are administered through the tax code include the NMTC,²² the low-income housing tax credit (LIHTC),²³ and the tax credit for the rehabilitation of historic structures.²⁴ Below is a brief discussion of potential economic effects of OZs.

Effects on Employment

Current place-based economic development tax policies tend to be structured to directly benefit owners of capital who invest in particular communities or in particular types of projects and to indirectly benefit the residents of low-income communities. The OZ tax incentives follow this structure by delivering a direct benefit to the owners of capital through capital gains tax relief. Benefits delivered in this manner effectively reduce the cost of investment (i.e., the cost of capital). Economic theory would predict that tax subsidies for capital would not directly benefit workers (e.g., in the form of higher wages).²⁵ While it is too soon for detailed analysis of the OZ tax incentives, research on the NMTC has shown limited effects on employment.²⁶

Effects on Investment

Studies find that place-based economic development incentives tend to shift investment from one area to another, rather than result in a net increase in aggregate economic activity.²⁷ Previous analysis of economic development tax incentives suggests that any one of these tax incentives on its own might be insufficient to generate a positive investment return from an otherwise unprofitable development project.²⁸ However, developers may be able to "stack" the benefits of multiple federal tax incentives (as well as any state and local incentives). The sum of these benefits could make a project located in one area more profitable than alternatives.

Revenue Effects

The Joint Committee on Taxation initially estimated that the OZ tax incentives would result in a revenue loss to the federal government of $1.6 billion over 10 years.³² Subsequent tax expenditure estimates were higher: a revenue loss of $8.2 billion over 5 years.³³ The revenue loss within the initial 10-year and most recent 5-year budget windows is due to the relatively small revenue losses associated with the deferral of capital gains tax and the OZ basis adjustments in years 5 and 7. The largest tax benefit associated with OZ tax incentives, the exclusion of capital gains tax on qualified OZ investment returns in year 10, would fall outside of the 10-year budget window. Those revenue losses would not be expected until 2028 (i.e., FY2028-FY2029).

Issues for Congress

Changing Designation of Qualified Opportunity Zones

Some Members of Congress have inquired whether Treasury or IRS have the authority to change designation of qualified OZs from one eligible census tract to another. One potential reason to change an OZ designation could be to support investment in an area that has more viable development projects for investors. However, the IRS has stated that such requests cannot be accommodated because IRC Section 1400Z-1 authorized only one determination and designation period for Treasury and IRS to certify and designate census tracts as qualified OZs.³⁴ Under this reasoning, new legislation would need to be enacted to change the amount of qualified OZs, open a new round of OZ designations (e.g., using the most recent economic data), or change criteria for qualified OZs.

Roles of Federal and Subnational Governments

The federal government played an active role in establishing the rules for OZs and continues to administer the tax benefits to QOFs that engage in OZ-eligible activities. Congress enacted OZs as part of the 2017 tax revision (P.L. 115-97). The Fund formally designated census tracts as QOFs that were eligible under the statutory criteria and nominated by state CEOs (e.g., governors). Treasury and the IRS then promulgated regulations on the OZ tax benefits and issued additional transactional guidance. As discussed more in "Coordination of Federal Economic Development Programs with Opportunity Zones," other agencies could assume a larger role in providing financial incentives for investment in qualified OZs.

Absent further congressional legislation, subnational governments will likely play a larger role in the types of individual projects and activities that will be supported by OZ investment. For example, governors and state legislatures could seek to promote OZs within their jurisdictions as attractive options for investment, or enact state-level incentives to enhance potential private-sector returns in OZs.³⁵ Like state officials, local government entities can also provide further incentives to attract OZ investments. Local zoning agencies and mayoral offices may have the most direct effect on what projects can proceed within specific OZs. These officials can approve or deny building permits, or grant approval of permits based on the projects meeting certain conditions (e.g., building height variances, promotion of certain goals about population density, mixed-income housing units).

Coordination of Federal Economic Development Programs with Opportunity Zones

In 2018, then-President Trump issued an executive order that created the interagency White House Opportunity and Revitalization Council, whose goal was to "encourage public and private investment in urban and economically distressed areas, including qualified opportunity zones."³⁶ This council, chaired by the Secretary of the U.S. Department of Housing and Urban Development, was tasked with assessing actions that each federal agency could take under its existing authority to prioritize or focus federal programs in economically distressed communities, including qualified OZs, and reduce regulatory and administrative costs that could discourage such public and private investment. Pursuant to the executive order, some agencies have promulgated regulations or issued press releases explaining how they are working toward these goals.³⁷

Proponents of such activities could argue that federal coordination of benefits could enhance the incentive effects of OZs. Examinations of past federal economic development incentives, such as the NMTC, have indicated that one federal incentive, alone, might not be sufficient to drive private-sector investment in distressed communities.³⁸ By "stacking" multiple government benefits in qualified OZs, though, economic development assistance could be more successful in driving private and public investment in qualified OZs. Critics of this approach could argue that such coordination could undermine assessments of the OZ tax incentives and could make the OZ tax incentives appear to be more effective in increasing economic outcomes than they would otherwise if measured in isolation.

Timeline of Tax Benefits

In order to benefit from the 10% (or 15%) step-up in basis for capital gains rolled over into a QOF and held for five (or seven) years, investors would have needed to roll over their capital gains into a QOF by the end of calendar year 2021 (or 2019). By doing so, investors would be able to obtain a full five (or seven) years holding period needed for the 10% (or 15%) basis adjustment.

Congress could decide that there was not sufficient time for QOFs to form and raise money from investors, who might have waited to participate in OZ investments until they conducted more research or reviewed developing regulations. To allow for more investments to qualify for the 10% (or 15%) step-up in basis, the mandatory recognition of deferred capital gains in IRC 1400Z-2 could be delayed to allow these benefits time to accrue. In the 117^th Congress, H.R. 7467 would extend the OZ deferral period through the end of 2028 and allow the 15% step-up in basis on a six-year holding period and H.R. 970 would extend OZ deadlines by two years. Critics of such proposals, however, could oppose such policies, citing a concern that the OZ tax incentives largely benefit investors, rather than low-income communities and their current residents.

Congressional Oversight

Congressional oversight of OZs has focused on how they are designated, their efficacy as a means to increase investment in low-income areas, and their reporting requirements. Each issue is discussed below.

Designation of Qualified Opportunity Zones

Some Members of Congress have expressed concern that politically connected individuals might have had an unfair or improper influence on the geographical designation of certain census tracts as qualified OZs. Reports alleging such influence have been published in various media outlets.³⁹ In 2019, Senator Cory Booker, Representative Emmanuel Cleaver, and Representative Ron Kind sent a letter to Acting Treasury Inspector General (IG) Richard Delmar asking that the designation process be investigated.⁴⁰ The Treasury IG has reportedly accepted that request, although the exact scope of the investigation has not been publicly disclosed.⁴¹

Related to this issue, the Urban Institute previously analyzed the census tracts designated by the CEOs of the states and the District of Columbia, "scoring" each against measures of the investment flows they are receiving and the socioeconomic changes they have already experienced.⁴² Tracts that were selected by the state's respective CEO and designated as QOZs were compared with eligible, nondesignated tracts not selected by the CEO. CEOs in Montana, DC, Alaska, and Georgia selected areas with the lowest levels of preexisting investment.⁴³ Conversely, CEOs in Hawaii, Vermont, Nebraska, and West Virginia selected areas with the highest levels of preexisting investment. Additionally, the researchers found

Designated [OZ] tracks [sic] do have lower incomes, higher poverty rates, and higher unemployment rates than eligible nondesignated tracts (and the US overall average, which is as expected given eligibility criteria). Housing conditions trend in similar ways, with lower home values, rents, and homeownership rates. The designated tracts are also notably less white and more Hispanic and black than eligible nondesignated tracts. Age compositions are comparable. Education levels are somewhat lower among designated tracts than eligible nondesignated tracts.... In terms of this program, there appears to be no targeting on the basis of urbanization.⁴⁴

In the 117^th Congress, several bills would modify OZ designations. H.R. 7467 would allow state CEOs to remove OZ designations from tracts where median family income now exceeds 130% of the national median family income and allow those CEOs to designate a replacement census tract, while H.R. 4177 would allow state CEOs to designate an additional 5% of the state's eligible census tracts, and H.R. 1740 would designate all of Puerto Rico as an OZ.

Efficacy of OZs to Improve Economic Conditions of Low-Income Areas

In 2019, House Ways and Means Committee Chairman Richard E. Neal, Senate Finance Committee then-Ranking Member Ron Wyden, House Ways and Means Oversight Subcommittee then-Chairman John Lewis, and Senator Cory Booker wrote a letter to GAO requesting it to "study the [OZ] program to review its effectiveness in spurring investment in low-income areas compared to other federal incentives, zone designations and program compliance."⁴⁵ Among several research questions, the request asked GAO to compare OZ tax incentives to other economic development tax incentives, such as the NMTC and LIHTC, and compare the characteristics of census tracts that were eligible but not designated to those that were designated. GAO issued its final report in October 2020 and found that OZs have fewer limits on permissible project types and fewer controls to limit revenue losses.⁴⁶ GAO also found that insufficient data were being collected to evaluate OZ performance. GAO found that addressing the latter concern may require congressional action.

Early academic research on Opportunity Zones has generally found modest to no effect on economic outcomes. Focusing on employment, preliminary evidence is mixed, with research using establishment-level data finding the reduction in capital gains taxes for OZ investment increasing job growth by 3 to 4.5 percentage points relative to census tracts that were eligible but did not receive OZ designations.⁴⁷ Other research using census tract-level data and controlling for predesignation trends fails to find an effect on employment, and research focusing on job postings also fails to find an increase in job postings in OZ census tracts.⁴⁸ Other preliminary research has found initial OZ investment to be concentrated in a limited number of designated census tracts that appear to have positive predesignation economic trends⁴⁹ and little to no initial effect on housing prices.⁵⁰

Data and Reporting Requirements on Beneficial Investors and Projects

Testimony before some committees has reinforced suggestions that Congress lacks adequate information for oversight of OZ tax benefits and that further data-reporting requirements are needed.⁵¹ QOFs are not required by statute to provide periodic public reports on the locations of their investments or economic impacts of those investments on low-income communities. The ability of the IRS and Treasury to disclose such information is currently limited by general provisions protecting taxpayer confidentiality absent the taxpayer's consent.⁵² However, Treasury or Joint Committee on Taxation (JCT) economists could conduct an in-house study measuring the effects of the tax provision without publicly disclosing confidential taxpayer data, and Congress could amend taxpayer confidentiality rules to permit or require disclosure.

Under its existing authority, the IRS has sought public input on ways to modify the Form 8996, which is filed annually by taxpayers that have self-elected QOF status, to increase the amount of data collected on OZ investments.⁵³ Starting with the 2019 tax year (2020 tax filing season), the IRS now asks for more data on the value and location of qualified OZ property owned or leased by the QOF, as well as any qualified OZ stock or partnership interests.⁵⁴

Currently, data and metrics on investment in OZs are provided by government and private industry sources. For example, a working paper utilizing federal business tax returns indicated that $18.9 billion in new OZ investment was claimed on electronically filed returns and that roughly $6 billion in new OZ investment was claimed via paper returns.⁵⁵ The authors find that reported OZ investment is overwhelmingly concentrated in equity investments in businesses that specialize in real estate, construction, and finance. Novogradac, an accounting and consulting firm that focuses on economic development tax incentives, reported that a total of 1,035 QOFs nationwide had raised $28.37 billion in equity as of March 2022.⁵⁶ The names, contact information, and investment focus areas of QOFs that elected to provide such information are also listed on Novogradac's website, as well as other third-party sites.⁵⁷ Some of these third-party data sources also indicate the minimum investment required for an investor to participate in a particular QOF.

Several bills introduced in the 117^th Congress are intended to promote oversight and transparency of OZs. For example, H.R. 7467 would require QOFs to report the physical location of an OZ investment, the industry of the investment, and the number of jobs supported by the investment. The bill would also require investors to report information on their investments in QOFs that would allow the IRS the ability to link the investor to a specific QOF and to their deferred gains invested in a QOF.

More QOF disclosure on tax forms could aid the IRS in ensuring the proper administration of OZ tax incentives. Although the IRS would be limited in disclosing such taxpayer-provided data to the public without the taxpayer's consent, it could release some aggregated amounts of OZ investments organized at state or local levels or the tax benefits claimed by income level in order to provide the public with a better idea of how the direct benefits of OZ tax incentives are distributed. If substantial disclosure, public or private, were required by investors or QOFs, though, then that could be a disincentive for some participation in OZ-related investments. More detailed forms could also increase compliance costs for QOFs.

Appendix A. Illustration of CDFI OZ Mapping Tool

Figure A-1 provides an illustrative screenshot of the Fund's online mapping tool. This image displays census tracts that have been designated as a qualified OZ in the Southeast, primarily Alabama, Georgia, and South Carolina. Designated OZs are shown in blue. A complete list of qualified OZs is available on the Fund's "Opportunity Zone" website.⁵⁸

Figure A-1. CDFI Fund Mapping Tool Showing Designated Opportunity Zones (OZs) in the Southeast

Source: CRS screenshot of CDFI Fund, CIMS mapping tool, accessed November 11, 2018, at https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml. Notes: Designated OZs are shown in blue. Congressional district borders have been enabled in the above screenshot

Appendix B. Number of Census Tracts Eligible in Each State for Qualified OZ Designation

Table 2 displays the maximum number of census tracts in each state or territory that were eligible for OZ designation under each of the two nomination criteria. These data, from February 27, 2018, were posted on the Fund's website before the qualified OZ recommendations issued by state or territory CEOs were certified.