Opportunity Zone Investments

The Tax Cuts and Jobs Act created a new investment our clients need to be aware of. Referred to as the “Opportunity Zone” program, this new investment vehicle provides spectacular tax benefits for those who can take advantage of its features. This article explores the key aspects of investing in Opportunity Zones.

Overview

The purpose of this new program is to stimulate growth in certain economically- distressed communities. These communities were officially identified as Opportunity Zones in 2018. There are thousands of Opportunity Zones spread throughout the United States. To take advantage of the new tax provisions, a taxpayer needs to invest in a Qualified Opportunity Fund  (QOF) which then, in turn, invests in businesses and real estate located in Opportunity Zones.

Tax Incentives

There are two major aspects. The first part deals with the property invested into the QOF.  The second part deals with the investment in the fund itself.

Property Invested Into the Fund

A taxpayer is allowed to defer the recognition of capital gains if the gain is invested into a QOF within 180 days of when the property is sold or exchanged. This is similar, but not identical, to a section 1031 transaction. Unlike section 1031, the taxpayer only needs to invest the gain. A person could invest more than just the gain but the tax benefits only accrue to the invested gain. There is no need for a qualified intermediary.

Example 1: Allison sells her Intel stock on December 31, 2018, for $30,000. She bought the shares years ago for $20,000. She defers the $10,000 gain by investing in a QOF by May 30, 2019 (180 days).  Allison extended the filing of her 1040 until after she completed the investment.

The deferral of the original gain will continue until the earlier of December 31, 2026, or when she sells the stock.

If a taxpayer holds the investment for at least five years they receive a step-up in tax basis equal to 10% of the deferred gain

Example 2: Assume the same facts as before except that Allison holds her investment in the fund for at least five years. Her basis in the Intel stock is increased by 10% of the deferred gain, or $1,000.

If a taxpayer holds the new investment for at least seven years they receive an additional increase in the basis of 5% of the deferred gain.

Example 3: Assume the same facts as before except that Allison holds the new investment for at least seven years. Her basis in the Intel stock is increased by another 5% of the deferred gain, or $500. Her basis in the Intel stock is now $21,500 ($20,000+$1,000+$500).

Observation: For maximum benefit, the investment in the QOF must be made by December 31, 2019. This is because, by December 31, 2026 taxpayers will have to recognize the gain on the original sale even though they are still invested in the QOF. A person can invest after 2019 but there will not be seven years to capture the extra 5% reduction in gain.

Investment in the Fund

In addition to the deferral and potential reduction of capital gains invested into the fund, there are tax benefits from investing in the fund itself.

When the initial investment is made into the fund of deferred capital gains the taxpayer has zero basis.  After five years of holding the new investment, the taxpayer is allowed to increase their basis in the fund by the 10% reduction in deferred gain as noted earlier. After holding the new investment for at least seven years the taxpayer can increase their basis in the fund by the additional 5% in reduction of the deferred gain.  On December 31, 2026, when the remaining deferred gain is recognized the taxpayer’s basis in the fund can also be increased by the amount of recognized gain.

Example 4: From the previous examples Allison would have a basis in the Intel stock of $1,000 after five years and $1,500 after seven years and $10,000 ($1,000+$500+ $8,500) at December 31, 2026.

After holding the investment in the fund for at least ten years the taxpayer can choose to make the basis of the fund equal to its fair market value. This would mean there would be no gain to recognize when the fund was sold. However, the adjustment to fair market value is optional. If the value in the fund decreased the taxpayer would want to keep a higher basis in order to take the loss.

Summary

This new investment is a great tax opportunity, however, clients need to be careful of making a sound investment.  It may take a while to identify the truly solid investments and reliable fund managers.

John M. Stevko, CPA, has over 40 years of professional experience as a tax practitioner, national seminar instructor, writer, and business owner. John began his career with what is now a “Big 4” public accounting firm before founding a local CPA firm in Beaverton, Oregon. At that same time, John began speaking for Gear Up Tax seminars and eventually becoming a managing partner of the business. John has lectured on tax law and healthcare reform throughout the country at national conferences and in-house for top 100 CPA firms and the large banking industry. He has also appeared on television and radio programs seeking his expertise on tax and healthcare legislation.