As part of the 2017 Tax Cuts and Jobs Act, the IRS designed an “opportunity zone” program with the purpose of increasing capital investment into distressed or low income communities throughout the United States. The program offers, in my opinion, significant tax benefits and incentives to investors (with recently recognized capital gains to re-invest).
Our firm is currently involved in a few opportunity zone projects, including the formation of an “Opportunity Zone Fund”. Our work includes structuring the fund, navigating the tax regulations, and handling the securities offerings and compliance. We are often asked how to go about investing in the Opportunity Zone program and the pros and cons of doing so. And because there are limited zones and timelines, the competition can be high. You can find the list of designated opportunity zones here.
In this article, we focus on high-level tax implications, investment requirements, and capital gains. As is the case with anything involving tax regulations, the devil is always in the detail. Thus, in lieu of bogging you down with tax regulations, we’re going to focus on the main features of the opportunity zone program.
Investors investing in an opportunity zone fund can potentially realize the following tax benefits. However, it’s important to note that the following tax benefits are only available to the extent the investor uses cash from capital gains (short term or long term) within 180 days of the gain recognition. Using non-capital gains funds will not achieve the following tax benefits.
- Deferral of Tax on Capital Gains. The tax payable on the capital gains invested into an opportunity zone fund can be deferred until December 31, 2026. That’s nearly 7 years of tax deferral.
- Elimination of a Portion of the Tax after 5 and 7 years. If the investor holds the interest in the opportunity zone fund for 5 years, then the tax basis in the fund interest is increased by 10%. If the investor holds the interest for 7 years, the tax basis is increased by an additional 5% (for a total of 15%). So, if, for example, an investor invests $1 million into an opportunity zone fund and holds it for 7 years, then, the investor would only pay tax on $850,000 of the gain.
- No Gain on the Sale or Exchange of the Opportunity Zone Fund Interest. If an investor holds its interest for at least 10 years and subsequently sells or exchanges its interests in the opportunity zone fund, then the investor’s gain from it’s initial investment is tax-free. So, using the $1 million initial investment from the previous example, if the fair market value of the investment grew to, say $1,750,000 after 10 years, then the $750,000 in gain realized in the sale of the investment would not be subject to additional tax.
Opportunity Zone Fund Basics
In order to qualify as an opportunity zone fund, the fund needs to hold assets that consist of at least 90% of qualified opportunity zone property. Qualified opportunity zone property can take the form of (i) newly issued stock in a corporation, whose trade or business is a qualified opportunity zone business (ii) partnership interests in a partnership (or LLC) whose trade or business is a qualified opportunity zone business, or (iii) tangible property (including real property) if such property was purchased from an unrelated party after December 31, 2017, the fund “substantially improves the property”, and such property is located within a designated opportunity zone.
As you can see, we glossed over many of the details of the tax rules. There are subtle rules in the proposed regulations that require proper care when forming a qualified opportunity fund or investing through one. If you’re considering this, you’ll need an experienced corporate legal counsel to help navigate the risks and steer your through process correctly. Get in touch with us today to learn more about how we can help.
- In 2018, the Economic Innovation Group produced an interesting illustration of capital gains invested and how it is projected to perform over 10 years compared with a traditional stock portfolio. Click here to read their fact sheet.
- Fundrise.com has a calculator to estimate how much you could save on capital gain
- IRS FAQs on Opportunity Zones
- Contact information for The U.S. Department of the Treasury Community Development Financial Institutions Fund