Many investors are sitting on unrealized capital gains from the appreciation of stocks, business value or real estate out of a fear of needing to pay significant capital gains taxes on their outsized returns. While there have long existed ways to defer these taxes, most options have had numerous drawbacks and limitations, dissuading investors from utilizing them.
With last year’s introduction of Qualified Opportunity Zones, investors now have a way to not only defer paying capital gains taxes, but to even reduce them, and eliminate new capital gains taxes on their subsequent investment. This relatively new tax benefit program was created from the Tax Cuts and Jobs Act (TCJA), which was signed into law in 2017, to help spur investment in historically distressed areas around the country.
After the initial release of the program, investors were hesitant as many questions remained unanswered. A subsequent clarification in May 2019, while positive, still left many in the dark about substantive issues. However, the Internal Revenue Service (IRS) released final Opportunity Zone regulations on Dec. 19, 2019 and the general consensus is that the program is very investor friendly.
Where are Opportunity Zones?
Opportunity Zones are census tract areas that were designated for tax benefits by the state and federal governments as a part of the Internal Revenue Code, as a result of the passage of the TCJA. They were selected through a nomination process whereby state governors sent their recommendations to the U.S. Department of the Treasury for consideration.
There are 8,762 Opportunity Zones, comprising different census tracts in all 50 states, Puerto Rico and all other U.S. territories. Also, there are Opportunity Zones in urban, rural and suburban areas.
Investors can take advantage of this program by investing capital gains into a Qualified Opportunity Fund, which is an entity that was created for the purpose of investing in businesses or properties located in an Opportunity Zone.
What are the main tax benefits of investing in an Opportunity Zone?
The extensive tax benefits are what have made the Opportunity Zone program so appealing to many. These benefits can be broken into three categories – current capital gains, future capital gains, and cash distributions during the investment term.
Current Capital Gains
As mentioned above, many investors refrain from selling assets because they don’t want to have to pay capital gains taxes. According to the Economic Innovation Group, there are an estimated $6 trillion worth of unrealized capital gains in the U.S.
For any capital gains properly invested in an Opportunity Zone, taxes due on such gains are deferred until Dec. 31, 2026, unless the investor sells their investment before that date. Additionally, if the investment is held for at least five years (meaning the investment was made prior to Dec. 31, 2021), the basis of the capital gain will be stepped up by 10%. This means that when the investor has to pay the deferred capital gains tax at the end of 2026, they are paying the tax on 10% less gain than had they paid the tax when they initially realized the gain. Notably, this deferral and reduction in basis applies not only to long-term capital gains, but even short-term capital gains, which are typically taxed at the higher ordinary income tax rate.
Future Capital Gains
Perhaps, however, the most appealing aspect of the Opportunity Zone program is not the deferral of the initial capital gains or reduction in basis. Rather, it’s the fact that if the investment is held for 10 years and some other requirements are met, any tax on the capital gains on the investment in the Opportunity Zone is completely eliminated. Therefore, when the investor ultimately sells their investment, there will be no tax due at all on the gains on such investment.
Cash Distributions During Investment Term
As the Opportunity Zone property is developed and put in service, the sponsor may be able to distribute operating cash flow to its investors. The cash flow distributions are generally not subject to tax. In addition, as the property increases in value, the sponsor may refinance the property loan. Any proceeds from the refinance distributed to investors are also generally not subject to tax.
Why were Opportunity Zones created?
If this program sounds too good to be true, it may help to understand the intentions behind its implementation. Opportunity Zones were mainly created to provide investments to areas that have been historically underserved in an effort to spur economic development and jobs to those areas. This is why the tax benefits to investors are not immediate but require holding the investment until the end of 2026 to see some benefits and for at least 10 years to reap the full benefits of the program.
Additionally, the investment must be a new property or business, or the Opportunity Fund must substantially improve the investment, which is defined as at least doubling the basis — or the original amount spent acquiring the business or property (excluding the amount allocated to land). Also, an Opportunity Zone business is required to earn at least 50% of its gross income each year from business activities from within an Opportunity Zone.
These requirements of time and dollars ensures the program won’t become a get-rich-quick scheme for investors. Rather, investors have to be willing to leave their capital gains invested for many years and use them to improve the area, and only then can they reap the rewards.
How to Invest in an Opportunity Fund
While investing in an Opportunity Zone is considerably easier than utilizing other capital gains tax deferral programs, there are still many considerations that must be taken into account.
First, one must have short-term or long-term capital gains to invest in order to benefit from the program.
Additionally, there are many important dates and regulations that investors must keep in mind when considering an Opportunity Zone investment. Generally, investors have 180 days after realizing capital gains to invest those proceeds in an Opportunity Fund. For investors in partnerships or S Corporations, if their entity realized capital gains but choose not to defer them and just pass them down to its partners, those partners can elect to start their 180-day period from the last day of the tax year (Dec. 31) or from March 15 of the following year (which is the day the partnership’s tax returns are due, without extension) rather than the date of realization.
The Opportunity Fund must then invest the capital gains into a Qualified Opportunity Zone Business by the closer of two testing dates: June 30 and Dec. 31. However, in the first year, the Opportunity Fund can ignore the first testing date, giving it some additional time to locate and invest in the Opportunity Zone Business.
Another important date for investors to be mindful of, as noted above, is Dec. 31, 2026, because that’s when capital gains taxes on the initial invested capital must be paid. Investors want to be sure to plan accordingly.
Notably, neither an investor nor an Opportunity Fund has to be located within an Opportunity Zone to invest in one and receive the tax benefits.
The Opportunity Zone program is an incredible tool for investors to realize their capital gains, reduce their taxable basis and eliminate new capital gains – all while putting their money to work in improving underserved areas. However, it’s important that investors aren’t blinded by these tax benefits and ignore the reality that the underlying investment opportunity must still make financial sense. An Opportunity Zone can make a good deal even better, but it won’t transform a bad deal into a good deal. By their nature, Opportunity Zone investments can be somewhat riskier investments as they are located in neglected or distressed areas. Investors should make sure to do their due diligence and ask the right questions. Is the business plan compelling? Is the sponsor experienced in ground-up development or extensive rehabilitations? With the right sponsor and the right deal, Opportunity Zones can provide a potentially lucrative opportunity.