Sep
Article by: Jeff Skolnick, CPA, M.S. Taxation
According to the IRS website opportunity zones were created to “spur economic development and job creation in distressed communities.” They are investments created where if certain rules are met, will provide preferential tax treatment for investors. These zones were created as part of the Tax Cuts and Jobs Act in December of 2017.
In order to qualify as an opportunity zone a locality must have been nominated by its state and certified by the Secretary of the US Treasury through the Internal Revenue Service.
How exactly do these opportunity zones work?
Individuals, partnerships, LLCs, S corporations and C corporations are all eligible to receive the benefits of investing in opportunity zones.
The first thing that occurs is one of the entities listed in the previous paragraph invests either a short-term or long-term capital gain within 180 days of recognizing that gain. The date of recognition would be measured from the date of sale for transactions such as real property (land, commercial buildings or residential real estate), trade date if you are selling stocks, bonds, etc. or the last day of the taxable year if your capital gain came to you by way of a K-1 from a pass-through entity (such as a partnership or S corporation). The election is made with your tax return. For example, if you sold a commercial building in 2018 and realized a $500,000 gain and you reinvested it in an opportunity zone fund within 180 days you would elect on your 2018 income tax return to defer the gain.
Let’s stay with the $500,000 gain example. You realized a $500,000 long-term capital gain upon the sale of property in 2018 and invested in a qualified opportunity zone fund within 180 days and properly made the election to defer the gain on your 2018 return. Keep in mind this will also work with short-term gains and the capital gain may have arisen from the sale of stocks, bonds, etc. or come to you through a K-1 from a partnership or S corporation. The problem with capital gains coming from K-1s is that they must be invested within 180 days of the year end and many times taxpayers are unaware that there are capital gains until months after the yearend, however, if an S corporation, LLC or partnership you invested in has large capital gains hopefully you will have an idea before year end and can plan accordingly.
Unlike Section 1031 exchanges (which I’ve covered before) only the capital gain portion of the proceeds must be invested in order to take advantage of the tax benefits. If you remember when you are dealing with a 1031 exchange (selling for example a piece of property and deferring the gain by purchasing another property) you must invest the entire proceeds of the property sold or you will pick up some gain (meaning you cannot defer the entire gain).
Again, we go back to the $500,000 gain realized. The gain is deferred until the earlier of the date you sell the opportunity zone fund or December 31, 2026. Your gain on that date will be the lesser of your deferred gain or the fair market value of the qualified opportunity zone fund, less your basis in the fund. Your basis in the fund is 10 percent of your deferred gain originally invested if you’ve held your investment for 5 years or 15 percent of your deferred gain if you’ve held it for 7 years. Keep in mind in order to hold your investment for 7 years by December 31, 2026, the funds must be invested by December 31, 2019.
Let’s say you invested your funds March 1, 2019, which is within the 180 day requirement and hold the investment. On December 31, 2026 you must now recognize the capital gain We will further assume your investment is now worth $1,000,000. Originally you deferred $500,000. Your deemed sale will be $500,000 (the lesser of the gain you deferred or the fair market value of the fund of $1,000,000). If your investment in the fund had a fair market value of $400,000 on December 31, 2026, then $400,000 would be used as the sale price since it is lower than the original deferral of $500,000. However, remember since you held the investment for 7 years your basis in the $500,000 is 15% or $75,000. You will pay tax on $425,000 of capital gain income. You have saved income tax on $75,000 of capital gain and deferred paying tax on the $425,000 for 8 years. Keep in mind if the investment was held for more than 5 years but less than 7 years than you would exclude 10% ($50,000) instead of the $75,000, and therefore pay income tax on $450,000 of gain.
Now your basis in the opportunity fund is $500,000 ($75,000 for holding the property 7 years plus the $425,000 recognized in your tax return in 2026). If you were to sell your share of the opportunity zone fund the next day you would recognize a $500,000 gain (assuming the fair market value is still $1,000,000). This figure comes from the fair market value of your investment in the fund of $1,000,000 less your basis of $500,000 (which we previously calculated). If, however, you hold on to your opportunity zone fund investment for at least 10 years then your basis in the fund becomes its fair market value. Let’s say on May 15, 2029 your investment in the opportunity zone fund is $1,200,000 and you decide to sell it. Since you’ve held your investment in the opportunity zone fund for more than 10 years your basis becomes the fair market value of $1,200,000 (similar to a step-up in basis which occurs in Estate situations). Now you have taken a $500,000 capital gain and eliminated tax on $75,000 (because you held the investment for 7 years before December 31, 2026) and $700,000 because you held the opportunity zone fund for more than 10 years. To summarize, you realized $1,200,000 of capital gains, eliminated tax on $775,000 of capital gains and deferred tax on $425,000 for 8 years.
Opportunity zone investments are very new and I absolutely could not urge any stronger that you discuss this type of investment with both tax professionals and individuals with a formidable reputation when dealing with the actual investment.