Opportunity Zones: A Hidden Gem for Capital Gain Deferral
There is a program in the recently passed tax reform act that allows investors to defer capital gains (and possibly completely remove) when gains are reinvested into low-income communities.
By: Ben Riehle, CEO/Co-Founder Apex Real Estate Network
(Opportunity Zones: A Hidden Gem for Capital Gain Deferral) – First off, I am not a CPA or Tax Attorney. While I do have an accounting degree and J.D. specializing in Tax Law, I went the route of real estate practitioner. Please use this article as a starting point to perform your own research. I strongly recommend speaking with a tax professional that is familiar with your specific situation.
The Tax Cuts and Jobs Act of 2017 has a relatively unnoticed, yet extremely beneficial clause that can provide a substantial tax deferral opportunity to investors with capital gains from the sale of real estate, stocks or other assets. There are ample articles that examine and explain the details of the tax code; below is a general overview and link to articles that I found helpful in understanding how the Opportunity Zone Program works.
In the simplest terms, if the capital gains produced from an investment are reinvested in designated “Opportunity Zones” through a designated “Opportunity Fund” the capital gains that an investor would be required to recognize as income are deferred. The deferral of the capital gains must be recognized when the investment in the opportunity fund is sold or on 12/31/2026. There is the potential that Congress will extend this recognition date, which under the current program could result in the invested capital gains becoming tax-free.
I know you have about 1,000 questions right now. Is this too good to be true? What is the catch? Am I going to go to jail for tax evasion? If you want to dig into the weeds and get clarity on the details of this program check out: Bloomberg Tax Report
10,000-foot view to see how this all work
Now, if geeking out on a 7-page tax article and getting into the tangled web that is the Internal Revenue Code is not something that interests you, then keep reading as we take a 10,000-foot view to see how this all works.
Policy Intent: The federal government is aiming to incentivize investment in impoverished communities. Each state will be able to designate census tracts that are “low-income” and in need of capital investment as “Opportunity Zones”. The theory is that by providing a substantial tax deferral mechanism to investors, areas that would otherwise never receive major capital infusion will receive capital investments which will improve the communities. Please note, there are counter arguments about the effect of this policy and the gentrification that could potentially result. I will leave these challenges to the legal scholars and policymakers.
Opportunity Zone: “A ‘qualified opportunity zone’ is any population census tract that is a ‘‘low-income community’’ (qualified census tract) that is timely nominated as an Opportunity Zone by the governor of a state” The governor of each state is able to select up to 25% of all qualifying “low-income communities” in his or her state. It is important to note that the governor of each state had until March 31st 2018 to identify Opportunity Zones or potentially lose the ability to do so.
Opportunity Fund: “An Opportunity Fund is an investment vehicle, organized as a corporation or partnership that specializes in aggregating private investments and deploying that capital in an Opportunity Zone
- Investors may reinvest capital gains from existing investments into an Opportunity Fund and defer/reduce capital gains taxes
- If held, the original investment’s tax basis increases by 10% after five years and by 15% after seven years
- After 10 years, investors permanently eliminate capital gains tax on the post-acquisition gains”
The Opportunity Fund must invest 90% of the Fund’s capital in Opportunity Zones. There are numerous requirements to becoming and staying in compliance as an Opportunity Fund that are outside the scope of this article.
How to Invest: Unlike a 1031 Exchange, the investment in an Opportunity Fund only requires the investment of capital gains, not the entire investment (basis) plus gains. Additionally, you are not required to use a third party trustee to handle the proceeds from the sale of the investment prior to deploying in the new investment (like you do with a 1031 Exchange). The tax code requires that the investment in the opportunity fund occurs within 180 days of the disposition of the asset that triggered the capital gain. With opportunity funds being such a new concept there are still numerous clarifying questions still to be answered in terms of investment opportunities available and how the process will work (CONSULT TAX PROFESSIONAL!).
A Look at The Number: Virtua Partners put together a fantastic breakdown of the numbers comparing a traditional investment where the capital gains are recognized and paid vs. investment in an Opportunity Fund. See their example here: Virtua Partner Case Study
In Conclusion: This program is still very new and there is much uncertainty regarding all aspects of the capital gains deferment. It appears that at least a majority of the deferred capital gains may be recognized at some point in the investment life (there is a 5 and 7 investment holding period benefit that reduces the capital gains 10-15%). Currently, it appears that the invested capital gains will be recognized but deferred at least until 12/31/2026 and all future gains made while invested in the Opportunity Fund will be untaxed if the investment is held at least 10 years. A major concern is the requirement of “phantom income” being required to be recognized on the invested capital gains on 12/31/2026. This means if you invest in an Opportunity Fund and are still invested on 12/31/2026 the current requirement is the invested capital gains be recognized at that time. However, if Congress extends the recognition requirement it is possible that all invested capital gains may ultimately become untaxed.
By now you probably have more questions than answers; for that I apologize. At this point it is most important to know that there is a provision in the tax code to defer capital gain income. Obviously, this strategy will not be right for everyone, but knowing this option exists may just save you thousands of tax dollars.
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 §1400Z–2. Special rules for capital gains invested in opportunity zones
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