The new tax law passed last December certainly has its boosters and its detractors, but it also has written into it something that appears to be a proverbial win/win. While this new provision does offer tax breaks to those among us who receive capital gains, to get those breaks the advantaged must invest those profits in funds that benefit the disadvantaged. The shorthand for all of this comes down two words: Opportunity Zones.
To make certain our readers and clients understand the benefits of Opportunity Zones, our goal in this space is provide an overview of the new Opportunity Zone rules from the IRS, make clear the benefits of participating in the Zones, and give you a sense of what you and/or your firm must do to realize those benefits. Speaking of benefits, before we get into the details, we’ll hold out this carrot: Get onboard with Opportunity Zones and you might end up paying no capital gains tax at all.
So how does it work?
Let’s start at the source, the IRS.
The IRS defines an Opportunity Zone as “…an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” At this writing, there are about 8,700 Opportunity Zones and those “distressed” communities can be found in all 50 states, plus the District of Columbia, American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and the Virgin Islands. For a full listing of Opportunity Zones visit this link.
What’s gotten Opportunity Zones more attention since fall 2018 was the IRS unveiling regulations on October 19 that detail how investors can qualify for tax breaks by investing in underdeveloped/distressed communities. Apparently, not everyone waited for the regulations to come out. In fact, before October, several large financial firms were already up and running with investments in Opportunity Zones. To follow their lead, here is what you need to do.
To invest in a Qualified Opportunity Zone (the full and formal name of the Zones), you create an investment vehicle called a Qualified Opportunity Fund (QOF) that, according to the IRS, is set up either as a partnership or corporation (LLCs qualify also) for investing in an eligible property located in one of the Zones. The nuts and bolts of setting up your QOF, according to the IRS, begins when your eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return
There is one important caveat regarding how you fund the fund, if you will.
Perhaps you are top-heavy in company stock which is at an all-time high, and you want to cash in. Or, maybe you want to sell some or all of your business. In both cases you will get hit with capital gains tax. The good news about Opportunity Zone investing? Only monies from capital gains can be used to create a QOF. But if you want tax protection through a QOF, you need to act in a timely fashion.
No more than 180 days after the sale of your stock or business, you must put the proceeds into a QOF to qualify for the tax breaks that come with the investment. And they are as follows:
- You can defer capital gains tax on the money invested until the earlier of the sale date of the property or 2026.
- If you sell your Opportunity Zone property before five years, you will owe tax on the full amount of the deferred gain, assuming the sale price is greater than the deferred gain.
- If you sell your Opportunity Zone property after only five years, you will realize a 10 percent tax reduction.
- If you sell after seven years, your tax reduction goes up to 15 percent.
- Best of all, hold the property for 10 years and you pay NO capital gains tax on the appreciation on your investment.
How Much Should You Invest?
So, how do you determine how much of your capital gains to invest in an Opportunity Zone property? Obviously, properties qualifying for the program vary in value and cost. And location. Perhaps you prefer an inner-city commercial property that needs upgrading, maybe expansion. Or, maybe you’d like a more “Main Street America” location on the list of 8,700 Opportunity Zones. The choice is yours, as is how much you decide to spend. But do keep this IRS rule in mind:
After you make your purchase, you are also required to invest in renovations the equivalent of the market value of the building. The good news here is that it is JUST the equivalent of the building’s value. It does NOT include the value of the property on which it stands.
That makes urban locations even more attractive since the property value can be a substantial portion of the overall purchase price. The October 2018 regulations from the IRS also set out how long you have after your QOF is funded to get those renovations completed: 30 months.
While real estate is the dominant form of Opportunity Zone investment, there are domestic corporation stock options as well. For your investment in the stock to qualify for the program’s benefits, the stock had to be acquired after December 31, 2017, and at the time the stock was issued, the corporation had to have been a Qualified Opportunity Zone Business. Also, during substantially all of the QOF’s holding period, the corporation qualified as an Opportunity Zone Business.
It is also important to remember that your investment in an Opportunity Zone property is just that—an investment. As with any investment, you should expect to make back what you invested and realize a profit. With Opportunity Zones, while you are putting your money in what might be called “riskier” locations, those locations have been singled out by the federal government for special attention.
The goal is to improve the community, to make it more viable, more livable, which, in turn, can only improve the worth of your investment. In other words, it truly is a win/win, for the investor, the community and the people in it striving for a better life.
Example 1
On January 2, 2018, ABC Corp. sells property to an unrelated party and has a resulting gain of $1 million, which ABC Corp then reinvests in InvestFund, a qualified opportunity fund, on March 30, 2018. ABC Corp sells its investment in InvestFund on April 2, 2021, for $1.5 million. Since ABC Corp held its investment in InvestFund for under five years, its basis in the investment is $0. In its 2021 tax year, ABC Corp must recognize the deferred gain of $1 million as well as the $500,000 in appreciation.
Example 2
Assume the same facts as Example 1 above, except that ABC Corp sells the investment in 2025. Since the investment is held for more than seven years, ABC Corp’s basis increases from $0 to $150,000, thus reducing the amount of deferred gain it must include to $850,000 ($1,000,000 − $150,000). The additional $500,000 in appreciation must also be recognized.
| 10% of deferred gain— | $100,000 |
| 5% of deferred gain— | $50,000 |
| $150,000 |
Example 3
ABC invests $1 million of deferred gain in a qualified opportunity fund on January 1, 2025. On December 31, 2026, ABC must recognize the entire $1 million deferred gain ($1 million deferred gain less $0 basis) even though the investment in the fund has not been sold. The $0 basis in the investment is not increased because ABC has not owned the fund for at least five years. On January 1, 2037, ABC sells its interest in the fund for $1.5 million. Since ABC has held the investment for 10 or more years, it may elect to treat the basis as $1.5 million and no additional gain is recognized. If ABC does not make the election, its basis is considered to be $1 million (under the provision deferred gain that was previously recognized on December 31, 2026, increases basis) and $500,000 gain is recognized.
Example 4
Assume the same facts as in the Example above except that the value of the fund has decreased to $400,000. ABC will not make the fair market value election and recognizes a $600,000 loss ($400,000 less $1 million previously recognized gain).
The rules under the Qualified Opportunity Zone can be difficult so please contact your Prager Metis tax advisor with any questions you may have.
