New Opportunity Zone Law can Improve Depressed Neighborhoods, Yield Investors Significant Tax Benefits by Ed Cooper, CPA
Posted on June 29, 2018
In an effort to revitalize economically distressed communities around the country, Congress included in the Tax Cuts and Jobs Act a program that gives individuals and businesses preferential federal tax treatment when they reinvest capital gains into low-income communities. However, to reap the benefits of the newly enacted legislation and other valuable tax incentives offered by local governments, investors must understand how the program works and how they may qualify for it.
The Basics of Opportunity Zone Investments
The new legislation gave governors the ability to designate up to 25 percent of their state’s low-income census tracts to serve as Opportunity Zones (OZs) eligible for capital investment. As of June 2018, the Department of the Treasury has certified 8,762 OZs representing all 50 U.S. states, the District of Columbia and five U.S. territories, which can now begin attracting private investment capital from the estimated $6 trillion in capital gains that individuals and businesses left unrealized at the end of 2017.
Under the law, investments in the form of business profits, publicly traded stock or appreciated property are to be pooled into Opportunity Funds (O Funds) organized as corporations and partnerships, and authorized by the Treasury to invest at least 90 percent of its assets in OZ businesses. For example, a fund may be earmarked to renovate existing commercial real estate or build new developments in an OZ, or a fund may focus on supporting the expansion of existing businesses in the OZ or incentivizing new businesses to open there. O Funds are similar to mutual funds, stock portfolios or other vehicles for which individuals expect a return on the capital they invest in the fund. However, investors in OZs receive economic benefits in the form of tax incentives and the more esoteric advantage of helping to improve the local community.
The Tax Benefits Available to Opportunity Zone Investors
In return for their capital, businesses and individuals may receive the following federal tax benefits when they roll over their unrealized capital gains from business and real estate investments into Opportunity Zone Funds:
- Temporarily defer tax on reinvested capital gains until Dec. 31, 2026, or the date the opportunity zone fund sells the investment, whichever occurs sooner;
- Permanently remove/exclude from taxable income the capital gains yielded from the sale or exchange of an investment in a qualified opportunity zone fund that investors held for a minimum of 10 years;
- Receive a step-up in the basis of an original investment by 10 percent when the taxpayer holds the investment in an opportunity zone fund for at least five years, and by an additional 5 percent when the investment is held for at least seven years, excluding up to 15 percent of the original gain from taxation.
The value of this preferential tax treatment is based on the amount of time the taxpayer holds his or her investment in the O Fund. The longer the holding period, the greater the tax benefit. Therefore, an investor could conceivably roll over into an O Fund the capital gains he or she earns from a stock portfolio, a mutual fund or the sale of highly appreciable property, such as real estate, and avoid capital gain tax when he or she holds onto the O Fund for 10 years. A more modest tax benefit is available when the holding period is between five and seven years.
As simple as this may sound, it is important to remember that the Investing in Opportunities Act is a part of the federal tax code and therefore requires taxpayers to meet certain criteria to realize the potential tax benefit. For example, capital gains must apply only to sales between unrelated parties. A developer who sells property A that he or she owns cannot defer tax when he or she reinvests the capital gains into property B that the developer, a member of his or her family or a subsidiary of its business owns. In addition, the reinvestment of capital into an OZ fund must be made within 180 days from the date the taxpayer realized the taxable gain. Moreover, investors must understand the rules guiding what qualifies as an equity investment eligible for reinvestment in an OZ for federal tax purposes. For example, eligible investments in real estate are limited to a taxpayer’s ownership interest in new construction or assets that will be improved substantially within 30 months of acquisition by the O Fund.
Individuals who own, invest in or develop commercial real estate in OZs can receive the added benefit of local tax incentives when their property is located in empowerment zones, community redevelopment agency (CRA) districts or other underserved neighborhoods that rely on public and public-private dollars to support job creation, affordable housing and business development. The challenge, for individuals and businesses is to understand how the creation of O Funds and investment in OZs can fit into a larger tax strategy and allow taxpayers to leverage these vehicles to maximum tax savings.
While final guidance on the application of the new law is pending release from the U.S. Treasury, taxpayers should meet with their advisors and accountant now to begin planning for the establishment and seeding of O Funds. The earlier one begins planning, the more prepared he or she will be to pull the trigger and rollover unrealized gains to receive the benefit of the law’s preferential capital gain treatment.
About the Author: Edward N. Cooper, CPA, is director-in-charge of Tax Services with Berkowitz Pollack Brant, where he provides business- and tax-consulting services to real estate entities, multi-national companies, investment funds and high-net-worth individuals. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.