For a limited time, investors can help reinvigorate distressed communities while deferring capital gains on profits earned elsewhere.
The 2017 Tax Cuts and Jobs Act created the Qualified Opportunity Zone program in order to offer tax incentives for investment in economically blighted communities. When you invest in an Opportunity Zone, you can defer and possibly reduce taxes on recognized capital gains.
If you will be subject to a large tax bill as a result of capital gains in the near future, an Opportunity Zone investment may be worth exploring.
An investment that defers capital gains
Opportunity Funds are investment vehicles that allow investors to defer capital gains for up to 10 years and possibly receive greater tax advantages. To do so, investors need to reinvest capital gains (from any investment, such as stocks, real estate or business interests) into certain census tracts, which are designated as Opportunity Zones.
Each state nominated communities they wanted included in the program. To qualify, census tracts had to meet a Low Income Community requirement or have a poverty rate of 20 percent or greater. The goal is that investments in these impoverished communities will promote sustainable economic growth and help narrow the gap between them and their more affluent neighbors.
There are approximately 8,700 Opportunity Zones nationwide, including all 50 states, Washington, D.C., and U.S. territories. You can find a list at cdfifund.gov/pages/opportunity-zones.aspx.
To qualify for the program, an Opportunity Zone Fund must have 90 percent of its assets in a qualified Opportunity Zone property and must make substantial improvements to that property. Those are defined as improvements equal to the fund’s initial investment in the property, over a 30-month period.
Three ways to save
Investors in an Opportunity Fund can potentially save taxes in three ways:
- Tax deferral. Taxable gains in an Opportunity Zone Fund are not recognized until 2026 or until the interest in the fund is sold or exchanged, whichever comes first.
- Capital gains tax deduction. When you defer gains through an Opportunity Zone Fund, you receive a 10 percent step-up in tax basis after five years and an additional 5 percent step-up after seven years. Due to the 2026 deadline, you’d have to invest in 2019 to get full advantage of the 15 percent step-up.
- No tax on appreciation. If you remain in the fund for at least 10 years, the capital gains tax is eliminated on the future sale of the investment. Essentially, the cost basis of the property becomes equal to the fair market value on the date of the sale. You do still have to pay the deferred taxes on your original investment.
Example scenario
Imagine you realize $250,000 in capital gains in 2019. If you roll those gains into an Opportunity Zone Fund within 180 days, none of those gains are taxable this year. After five years, you’ll earn $25,000 in stepped-up tax basis in the fund (10 percent of $250,000). After two more years, you’ll earn another $12,500 of stepped-up basis. At a 23.8 percent tax rate, that’s nearly $9,000 in tax savings.
Now, let’s say you waited until 2029 to sell the investment at an appreciated value of $450,000 (roughly 6 percent annual rate of return.) You’d have $200,000 in gain that would not be taxable. However, you’d still have phantom income on your original $250,000 investment (minus the 15 percent reduction), in 2026 when, per program deadlines, the deferred gain had to be recognized.
In total, that yields approximately $56,600 in tax savings over 10 years ($9,000 in capital gains deduction and $47,600 in capital gains tax eliminated). Your 10-year net, in this scenario, is just shy of $400,000.
Instead, imagine you’d paid the capital gains tax on that $250,000 in 2019 ($59,500 at 23.8 percent) and then reinvested the remainder ($190,500) at a 6 percent annual return. If you sold the investment at the end of 10 years (at a value of $341,000) and paid capital gains taxes again ($35,700), you would net just over $300,000.
If you have questions about this new investment and whether it would be a prudent part of your wealth management plan, reach out to your estate planning attorney. Be sure you understand the investment risks involved.
Just like other investments, the fund may increase or decrease in value. Due diligence is essential when choosing funds, especially because this is a new incentive program.
