The Tax Cuts and Jobs Act of December 2017 was the most significant tax reform in decades. And while the business media has covered extensively the new tax bracket changes, the lower C corporation tax rate, and the Section 199A Qualified Business Income (QBI) deduction for pass-through businesses, most people aren’t aware of large potential investment tax breaks created through the creation of Qualified Opportunity Zones (QOZ). These QOZs allow investors to potentially garner some or all of three different significant tax breaks: capital gain deferral, capital gain reduction, and capital gain elimination.
The new QOZ program aims to promote economic growth and job creation by unlocking capital in low basis investments. The program allows an investor to roll any capital gain (real estate, stocks, bonds, mutual funds, ETFs) into an fund, partnership or corporation that invests at least 90% of the funds in property in the qualified opportunity zones.
Three Different Tax Breaks
For investors that meet initial and ongoing compliance regulations, and invest their capital into Qualified Opportunity Zone areas, there are up to three distinct tax breaks available to them:
Deferral of an unlimited amount of capital gains if the gain is invested within 180 days into an qualified opportunity zone fund (QOF).Taxes on the gain are due in 2027 or when the opportunity zone fund is sold, whichever is earlier.
A reduction by 10% of their capital gain if the fund is held for 5 years, and a reduction of the capital gain of 15% if the fund is held for 7 years.
Investors get to shield additional gains from taxation completely if they hold on to the opportunity zone fund investment for 10 years.
The tax savings in dollars can be substantial. For example, if an investor with a $500,000 property with a basis of $100,000 sold the property and bought a second property with the after tax proceeds, they would have $685,000 (up 37%) in 10 years once they sold the second property, assuming a 20% capital gains rate and a 6% rate of return. If they sold the property and purchased an opportunity zone fund investment, they would have $827,000 (up 65%) after-tax after 10 years, assuming the same rate of return and capital gains rate.
What are Opportunity Zones?
After evaluating 2010 census tracts with poverty rates of at least 20% (the national average is around 17%) or median income no more than 80% of the surrounding areas, the governors of the states and territories were able to nominate up to 25% of the qualifying areas. There are around 8,700 opportunity zones nationwide.Investors can receive tax breaks if they develop, significantly upgrade property, or fund a startup business within the opportunity zone.
Opportunity Zone Funds May Be an Alternative to a 1031 Exchange
Opportunity Zone Funds are most appropriate for people that have large stock capital gains or large real estate gains and are looking to sell those holdings. Real estate investors may want to consider the pros and cons of a QOF versus a 1031 exchange. A 1031 allows an investor to defer capital gains indefinitely by rolling the principal and gains into a new property. A QOF on the other hand allows the real estate investor to defer the capital gain for up to 7 years by reinvesting just the gain portion of the investment, but gives the investor access to their principal. Also, 1031 exchanges require that the newly purchased property be similar (“like-kind”), while QOFs do not. Unlike a 1031 exchange, the gain invested in a QOF doesn’t need to be tracked and escrowed; cash equal to the gain just needs to be invested within 180 days of the gain.
Using a QOF to Diversify your Investments
Opportunity Zone Funds can allow real estate investors the ability to diversify their stock or real estate holdings. To get diversification, one alternative would be to roll the gain from selling the non-diversified single stock position or single property into a diversified fund of opportunity zone projects through a Real Estate Investment Trust (REIT) structure. Several large REIT and private equity providers, including Sky Bridge Capital, have recently launched REIT funds to meet demand. These structures, typically only available to “accredited investors,” are easier to implement as they allow the investor to avoid the process of identifying and developing a stand-alone opportunity zone project.
Business owners that sold a company may also want to consider Opportunity Zone Funds so that they can defer or eliminate the hefty tax bill.
Potential Risks of QOFs
It’s worth noting that investors should be wary of having the tax benefits be the driving force of any investment. Like any real estate investment, there are a number of risks: the underlying investment with the QOF could go south, investments in QOFs are illiquid, Congress could potentially change the tax laws, QOFs involve monitoring and compliance paperwork, and QOFs incur taxable income in 2027 even if you continue to hold the investment.
As well, there isn’t substantial amount of time available for investors to get invested to get the maximum tax benefits. Given that this tax incentive expires on 12/31/2026, investors would have to be invested by 12/31/2019 to receive the maximum benefits of the 7-year gain reduction.
Opportunity Zones and Financial Planning
Before moving forward with a QOF investment, it’s important to talk to your CPA about implementation steps, filing requirements, and tax considerations, as well as talk to your financial advisor to think through if the investment makes sense for your overall financial plan.
David Flores Wilson,CFP®, CFA,is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.
