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Calculating opportunity zone benefits to compare investment risk and return

Feb 14, 2020

The math is easy when an investor with eligible capital gains is presented with two investment options that are identical in risk and return, but only one qualifies for opportunity zone (OZ) benefits. But what if the risk and return are not identical? This is where the investment analysis gets tricky. A lack of understanding can cause many investors and advisors to underestimate, or even discard, the potential benefits of the OZ option, and unknowingly choose an investment that offers higher risk or lower after-tax returns.

Here, we outline how to analyze the key components of OZ benefits so you can make an informed reinvestment decision when choosing between an OZ and non-OZ option. OZ investments offer three financial benefits:

  1. A deferral on paying the tax on the original capital gain until reported on the 2026 tax return;
  2. A discount on the deferred original capital gain when it is reported on the 2026 tax return; and
  3. A step-up in basis upon sale of the new OZ investment once held for 10 years or more.

Assuming no change in the future capital gain tax rate, all of the variables are known when calculating the first two benefits so quantifying and factoring into an internal rate of return (IRR) or return on invested capital (ROIC) is straight-forward. However, the 2026 cap gain tax rate is subject to change, and there are some proposals that may increase it significantly. . 

The rate in 2026 ultimately depends on the outcome of three congressional and two presidential election cycles. A change in cap gain rates could have a significant impact on the after-tax return on an OZ investment. Should capital gains rates increase, the deferred tax paid with the 2026 tax return would increase, but the OZ benefit of eliminating gains (including no recapture of depreciation) after the 10-year holding period would also increase, in the event the investment has appreciated in value.

Generally, the deferral and discount benefits on the original gain do not have a significant enough impact on IRR or ROIC to bridge the gap between two very different investment options.

The 10-year step-up in basis benefit (elimination of gain on the OZ investment) has the potential to be the most advantageous but it is challenging to quantify and include in an IRR or ROIC calculation because it represents taxes saved on the sale of the OZ investment 10 or more years in the future. Therefore, many investors disregard this factor in their analysis, which can lead to misguided investment decisions.

To achieve an “apples to apples” comparison between an OZ investment and a non-OZ investment, investors should consider after-tax cash proceeds on both the front-end and back-end of the analysis.  After-tax cash is an important and practical benchmark in the analysis because that is the amount an investor can actually use. We have developed an OZ benefits calculator to help you do just that. This tool will help you compare an OZ investment and a non-OZ investment by using the after-tax capital gain amount eligible for investing and calculating the rate of return needed on a non-OZ investment to yield the same after-tax cash proceeds as the OZ investment after 10-years. The calculator also enables you to customize current and future cap gain rates.

Example

A $500,000 OZ investment projects a 12% annual increase in value with gross proceeds at time of sale in 10 years of $1,552,924 (reduced to $1,442,010 after payment of the deferred and 10%-discounted original gain tax of $130,914 in 2026). Assuming no change in tax rates, to achieve the same amount of after-tax cash proceeds after 10 years in a non-OZ investment, the non-OZ investment would have to project an 18% annual increase in value.

Under the same assumptions but with an increase in the future federal cap gain rate from 20% to 35%, a projected return of 19.71% would be needed for the non-OZ investment to yield the same amount of cash as the 12% OZ investment.

Many investors may gravitate toward the higher projected reward but, in this scenario, both investments would yield the same amount of after-tax cash proceeds. Because risk and return are positively correlated (i.e., the higher the return, the greater the risk), investors selecting the non-OZ investment would be taking additional unnecessary risk without any after-tax upside.

To make a truly informed investment decision on how to reinvest the proceeds from your capital gain event, investors must analyze all three benefits of an OZ investment and apply a uniform benchmark when comparing OZ and non-OZ investments. 

OZ vs. non-OZ calculator

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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