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The new Tax Cuts and Jobs Act created a new opportunity for investors who can receive special tax incentives for investing in distressed areas. This program is called Opportunity Zones.
The purpose of this program is to “spur development and job creation in economically distressed areas.”
How can you invest in an Opportunity Zone? What is required and what kinds of incentives exist?
Background on Opportunity Zones and Qualified Opportunity Funds
To revitalize the economy, the 2017 Tax Cuts and Jobs Act introduced tax incentives for capital gains invested in a Qualified Opportunity Fund (QOF).
You may be able to defer and reduce capital gains tax if you invest capital gains in a Qualified Opportunity Fund. Aside from that, the gains realized by the QOF may become completely tax-free.
Qualified Opportunity Funds invest in Opportunity Zones. Each state may nominate areas to be classified as an Opportunity Zone and the Secretary of the U.S. Treasury certifies this nomination through the IRS. There are over 8,700 Opportunity zones in the District of Columbia, across all 50 US states and in five territories.
The Opportunity Zones benefit is valid from December 23, 2017 until December 31, 2026, unless the Congress decides to renew the program.
What is a Qualified Opportunity Fund?
The Qualified Opportunity Fund is a partnership or a C corporation investing in a Qualified Opportunity Zone. A business, which may be new or existing, has to self-certify that it is a Qualified Opportunity Fund by filing Form 8996 to the IRS.
The Qualified Opportunity Fund must use at least 90% of its assets to invest in a subsidiary operating in a qualified Opportunity Zone or to operate a business in an opportunity zone.
There are three main benefits of investing in Opportunity Zones
1. Deferral of capital gains on the original sale up until the QOF is sold or on December 31, 2026, whichever comes first.
The sale should have been made to an “unrelated” party. For this program, a shareholder who owned at least 20% of a corporation is a related party.
2. Taxable capital gains are reduced by 10% if the QOF is held for five years and reduced by 15% if held for seven years
3. Capital gains from the QOF are tax-free if the QOF funds are held for 10 years.
Here’s a scenario on what happens based on how long you hold the investment.
Deferral of the capital gains is not automatic. For this program, the taxpayer has to elect to defer the gain through Form 8949. You need to file this form together with your annual tax return for the year the capital gains tax is due.
The program is only open to new investments in a Qualified Opportunity Fund. Any investments made before the business became a certified QOF will not be eligible for preferential treatment of capital gains.
The investment made on the QOF should also be an equity investment made through the purchase of stocks or partnership interest. Investments made through debt instruments will not be eligible for this program.
Initial Transaction Example
If you sold stocks you acquired for $2 million at $5 million, you have to pay capital gains tax on $3 million ($5 million less $2 million). If you reinvest the capital gains in a QOF, you can defer the capital gains tax on the $3 million gain until you sell the investment or until December 26, 2027, whichever comes first. If you reinvest the $3M on traditional funds, you have to pay capital gains tax on the $3M right away.
If You Hold for 5 Years
If you hold your investment in a qualified opportunity fund for at least five years, you can avoid paying taxes on 10% of the deferred capital gain.
Following the example above, assume that the $3M capital gains invested in a QOF increase to $3.2M in five years. If you decided to sell by then, you have to pay capital gains tax on the following:
- $200,000 from the appreciation of your QOF ($3.2M less $3M)
- $2.7M from the $3M you reinvested in QOF. The deferred gains are reduced by 10% or 300K (10% of $3M) since you decided to hold your investment for 5 years.
Hold for 7 Years
If you hold your investment for seven years, the capital gains will be reduced by an additional 5%, decreasing the original capitals gains by 15%. If at this point, you sell the QOF at $3.3M, you have to pay capital gains tax on the following:
- $300,000 from the appreciation of your QOF ($3.3M less $3M)
- $2.55 M from the $3M reinvested in a QOF. At this point, the deferred gains are reduced by 15% or 450K (15% of $3M) since the QOF was held for at least 7 years.
To get a reduction in the original capital gains, the five-year and seven-year period should be within the program period which has a December 31, 2026 deadline.
Following this rule, you will only get this 15% reduction in capital gains if you invest in 2019. Beyond 2019, the seventh-year anniversary of the QOF will fall outside the program period.
Likewise, the five-year reduction in capital gains will only be applicable for funds you invest in until 2021.
Hold for 10 Years
If you hold the QOF investment for ten years, you can reduce capital gains by 15% in the seventh year and exclude any capital gains from the QOF investment when you sell. The only condition is that the investor MUST sell the QOF before December 31, 2047.
If on the 10th year, you sell your $3M investments on a QOF for $3.5M, you have to pay capital gains tax on:
- $2.55 M from the $3M capital gains reinvested in a QOF. On the seventh year, the deferred gains decrease by 15% or 450K (15% of $3M).
The 500K ($3.5 less $3M) gain is exempt from taxes if you held the investment for at least 10 years.
Approach QOFs with Due Diligence
Putting your money on a QOF is attractive for many investors. Reinvesting capital gains to defer or reduce taxes and receiving tax-free returns on investment could be an effective financial strategy.
There are substantial tax benefits for an investor, but these funds are not necessarily good investments. Like any other investment opportunity, think about the risks since some Opportunity Zones have high market risks. Even with the tax breaks, if a QOF is not profitable, it will be better to forego the incentive and choose a better investment.
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