Opportunity Zones allow investors who have any type of capital gains, to defer and/or save on taxes by investing all or a portion of it in real estate. These ‘Zones’ or OZ investments were created under the Tax Cuts and Jobs Act passed in 2018. This tasked Governors across the country with designating geographical areas and communities that needed a jumpstart economically.
In theory, the OZ strategy would have a two-prong benefit;
- Help revitalize dilapidated areas and stimulate the economy with development and jobs, and
- Provide investors with an alternative to the 1031 Exchange and help them to defer and save taxes on capital gains
In a nutshell, this tax incentive allows investors to reduce taxable gains and possibly obtain tax-free growth. This can occur if they re-invest capital gains into real estate within designated Opportunity Zones. This strategy can produce incredible benefits. However, the window of opportunity is relatively short (especially if you consider the full development cycle). You won’t want to sit on the sideline for very long!
The provision provides two stages of tax benefits for those who invest in such a Zone:
- Tax deferral and incremental step-up in basis for funds used to purchase a property in an Opportunity Zone, resulting in partial capital gain exclusion.
- Complete capital gain exemption for the new long-term investment interest in OZ.
WHO: The law mandates that tax incentives are available to Corporations and Partnerships holding at least 90% of their assets in OZ. The partnership or corporation must be organized for the specific purpose of being an investment vehicle in OZ. It must also be established after December 31, 2019.
Because of this, you will most likely need a new entity for your OZ funds. We at KKOS Lawyers can gladly guide you through the OZ process and at the same time, set you up with the proper entity.
WHERE: The Governor of each state has to designate a census tract as an Opportunity Zone. The most up-to-date OZ map can be found here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx. Make sure when you view the map you have the proper layer selected (i.e. “Opportunity Zone Tract”). Generally, opportunity zones are places in your state with lower incomes and higher unemployment rates.
WHAT: The capital gain amount the taxpayer wants to defer must be invested in an already-existing rental property or rehab property to ultimately be used as a rental property. The property must be acquired after 12/31/2019, be substantially improved, and the adjusted basis in the property must have increased while in the hands of the LLC.
HOW: In order to qualify, a taxpayer must invest in an OZ property within 180 days of recognizing a capital gain from the sale or disposition of property for cash. The beauty of this legislation is two-fold:
- The capital gain can be from the sale of stock, real, or personal property.
- Only the gain amount needs to be re-invested, not the entire sales proceeds (like a 1031 exchange). For example, if you sell a stock for $200,000 and have a capital gain of $50,000, you only need to invest the $50,000 in OZ property in order to take advantage of the tax incentive.
WHY: Once the investment in the OZ property is made, there are four benefits a taxpayer can take advantage of:
- The gain on the sale is deferred until you divest of the OZ property, or until December 31, 2028, (whichever comes sooner). This is a benefit right out of the gate and, practically speaking, is an interest-free loan from the IRS. You don’t have to pay the tax for possibly several years.
- If you hold the OZ investment for 5 years, you qualify for an increased basis of 10% on the deferred gain. Another way of saying this is you reduce the taxable gain by 10%.
- If you hold the OZ investment for 7 years, you get an additional 5%-increased basis on the deferred gain. This means you only pay tax on 85% of the gain, which you have not paid for 7 years! Therefore, you get to decrease the taxable gain amount AND defer the tax bill to boot.
- It gets better!! The biggest benefit is that if you hold the OZ investment for 10 years, you never pay any capital gains on the OZ investment! That’s right, if you keep it 10 years, you get a stepped-up basis to the market value on the day you sell or dispose of the OZ investment. However, you must remember two important points. A) you still pay taxes on at least 85% of the original gain amount. B) any operating income or net cash flow from the OZ investment along the way is taxable.
Clay, a real estate investor, owned a single-family rental. He decided he wanted to sell the property and invest into an OZ property OR an OZ ‘fund’. The Fund concept is a topic for another article here.
- Clay purchased the rental for $250,000 in 2010 and was able to sell the property for $500,000 in February 2018. For simplicity’s sake, let’s say his gain was $250,000.
- NOTE: Remember, Clay only has to re-invest the capital gain, and this could be capital gain on any asset. It could be capital gain on selling Amazon stock, gain from the sale of a business, or real estate.
- Within 180 days after the sale, Clay invested the entire $250,000 from the sale into an LLC (taxed as a partnership) with the express purpose of buying, rehabbing and renting multi-family housing units in an Opportunity Zone.
- Clay is able to defer the gain of $250,000 on the sale of his commercial building until 1) he sells the partnership interest, or 2) 12/31/2028.
- Let’s assume Clay never sells the property or his partnership interest, so he recognizes the gain on his 2028 tax return. However, he held the property for at least 7 years, so his basis in the original building has increased by 15% or $37,500. Not only does Clay get to save tax on the increased basis, but he also DIDN’T HAVE TO PAY TAX ON IT FOR 8 YEARS!
- It gets better, though! Because the OZ partnership rehabbing of the rental units went well, his initial investment of $500,000 is now worth over $1 million, and if he keeps the investment for at least ten years, (presumably mid-2030 under this example) he will never pay any capital gains on the partnership investment!
- Did we mention Clay has been receiving income from the rentals all along, as well?
Don’t forget to tell your accountant that you invested in a qualified opportunity zone. You also need to make sure they are up to speed on the strategy and process. Once you make the investment in the land or fund, you will make an election on your personal 1040 tax return for the year you would have reported the capital gain. In the example above, Clay would make the election on his 2021 return filed sometime during 2022. Here are two important “takeaways”:
- You need to make the investment now! You only have 180 days from the time you incur the capital gain to purchase a property in an OZ or buy into an OZ fund.
- For now, the capital gain is deferred until December 31, 2028. It means you need to get your 7 years started now to qualify for the partial gain exclusion to the fullest extent possible.
If you want to save on taxes when selling an appreciated asset and learn more, the IRS has posted some interesting FAQs. They are designed to help taxpayers take advantage of this amazing opportunity. The good news is, it’s easy, and much simpler than qualifying for a 1031 exchange.