An Opportunity Zone is a state-designated census tract where new investments may be eligible for preferential tax treatment. They were created by the Tax Cuts and Jobs Act on December 22, 2017 as an economic tool designed to spur development and job creation in distressed communities.
HOW DOES IT WORK?
To take advantage of the tax benefits associated with an opportunity zone investment, an investor must reinvest a capital gain in a Qualified Opportunity Fund within 180 days of a capital gains taxable event. Unlike a 1031 exchange, the capital gain can be from the sale of any type of asset: stocks, bonds, real estate, etc.
WHAT IS A QUALIFIED OPPORTUNITY FUND?
A Qualified Opportunity Fund is a partnership or corporation (LLC, S-Corp, C-Corp, etc) that is setup to invest in eligible property located in an Opportunity Zone. Capital gains generated from the sale of a prior investment must be used to “fund” the Opportunity Fund. Taxpayers can either self-certify as an Opportunity Fund or invest in a third-party Opportunity Fund to take advantage of the tax benefits.
WHAT IS A CAPITAL GAINS TAXABLE EVENT?
A capital gain taxable event occurs when an asset or security is sold for a higher price than the purchase price.
WHAT ARE THE TAX BENEFITS OF INVESTING IN AN OPPORTUNITY FUND?
Opportunity Funds present 3 primary tax benefits:
- A temporary deferral of capital gains. The deferred gain must be recognized on the earlier of December 31, 2026 or the date on which the investment is disposed.
- A 10% step-up in basis for the reinvested capital gains if investment is held for at least 5 years, or a 15% step-up in basis for an investment held at least 7 years. Think of this step-up in basis as a 10% or 15% reduction in your tax liability.
- A permanent exclusion from taxable income on capital gains from the sale of an Opportunity Fund investment if held for at least 10 years. In other words, capital gains tax will be owed on the sale of your original investment (10 years earlier), but no capital gains tax will be due on the profits created by the Opportunity Zone investment.
EXAMPLE 5, 7, AND 10 YEAR SCENARIOS
The below graphics compare the returns associated with investing capital gains in a traditional investment and an opportunity zone investment.
Assume: $100 of invested capital gains, 37.1% tax rate (California), 8% annual appreciation
5 Year Hold
- Deferral of capital gains for 5 years
- 10% step up in basis
7 YEAR HOLD
- Deferral of capital gains for 7 years
- 15% step up in basis
10 YEAR HOLD
- Deferral of capital gains through 2026
- 15% step up in basis
- Permanent exclusion of capital gains on Opportunity Fund investment
WHAT TYPES OF REAL ESTATE INVESTMENTS QUALIFY FOR OPPORTUNITY FUNDS?
For a real estate investment to qualify for the tax benefits within an Opportunity Zone, the investment must be part of a substantial rehabilitation. The Internal Revenue Service (“IRS”) defines a substantial rehabilitation as such that the development costs exceed the purchase price of the land or building in a 30 month period.
IS THERE A MAP OF OPPORTUNITY ZONES?
The map linked from Opportunity Fund Partner's site contains all of the currently designated Opportunity Zones: https://www.oppfundpartners.com/opportunity-zone-maps/
WHAT IS THE STATUS OF REGULATIONS THAT GOVERN OPPORTUNITY FUNDS?
The industry is still waiting on final regulations and further guidance from the IRS, anticipated to be released Fall 2018. One of the primary clarifications will surround the treatment of debt held by Opportunity Funds.
***Consult your attorney for legal advice, this is not a solicitation***