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A temporary deferral of inclusion in taxable income for capital gains reinvested into an Opportunity Fund. The deferred gain must be recognized on the earlier of the date on which the opportunity zone investment is disposed of or December 31, 2026.
A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis is increased by 10% if the investment in the Opportunity Fund is held by the taxpayer for at least 5 years and by an additional 5% if held for at least 7 years, thereby excluding up to 15% of the original gain from taxation.
A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in an Opportunity Fund if the investment is held for at least 10 years. This exclusion only applies to gains accrued after an investment in an Opportunity Fund.
Attention anyone with short and long-term capital gains as well as real estate investors:
If you’re considering development or redevelopment in a qualified “Opportunity Zone".
Under the recently passed Tax Cuts and Jobs Act- "TCJA" in December of 2017, new tax incentives are offered for investments within 8,766 designated low-income communities across the United States. This has laid the groundwork for one of the most unique and potentially community-changing tax deferment and avoidance opportunities we have ever seen offered by the IRS.
To provide some background:
The Opportunity Zone Program - a provision of the TCJA - allows each state to establish what are called “Qualified Opportunity Zones” (QOZ) in lower-income communities and disadvantaged “zones” within parameters set by the federal government. Each census tract has been nominated by the Governor of the state and that nomination must then be certified by the Secretary of the U.S. Treasury. Their purpose is to spur economic development and job creation in distressed communities by making it more appealing to investors to invest in such places.
A Qualified Opportunity Fund (QOF) is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in an Opportunity Zone and utilizes the investor’s gains from a prior investment for funding the Opportunity Fund.
The new tax law outlines 3 major incentives regarding Opportunity Zones:
There are a few important things to note about Opportunity Funds:
As mentioned, a taxpayer can sell any property (capital asset or other i.e. stocks, bonds, even a business that triggers short or long-term capital gains) and any amount of that gain that is invested by the taxpayer to a Qualified Opportunity Fund shall be excluded from gross income in the year of exchange (during the 180-day period that begins on the date of such sale or exchange). There is no dollar limit on the amount of gain that can be deferred under the temporary deferral election, but just one temporary deferral election can be made.
Example #1:
Let’s assume Mr. Smith sells property and realizes a gain of $500,000 on January 15, 2020. On February 15, 2020 (within the 180-day window) Mr. Smith invests $400,000 of the $500,000 gain in the QOF and Mr. Smith makes the temporary deferral election. A few weeks later, Mr. Smith invests the remaining $100,000 of the gain in the same QOF. The $100,000 is ineligible for a temporary deferral election because Mr. Smith already met the one-election limitation.
Example #2:
What if the facts are the same as in the above example except that Mr. Smith initially invested the entire $500,000 gain and an additional $200,000 from his savings account into the QOF? Since the investment exceeded his $500,000 gain on sale, the investment is treated as two separate investments into the fund. The $500,000 investment is subject to the temporary deferral election. The other investment of $200,000 is not eligible for deferral, even if it is all invested into the QOF on the same day.
The one-sale-limitation might also apply to a taxpayer who sold property on an installment basis and made a temporary deferral election applicable to gain recognized in the year of sale. In that case, the one-election-limitation might prevent that taxpayer from making a second temporary deferral election with respect to the gain recognized from installment payments received in tax years after the initial temporary deferral election. Why? Because the two elections would relate to gain from the same sale, similar to example #2 above.
In summary, here are the major benefits of investing in a Qualified Opportunity Fund:
The "Opportunity Zones" program is designed to incentivize patient capital investments in low-income communities nationwide. All of the underlying incentives relate to the tax treatment of capital gains, and all are tied to the longevity of an investor’s stake in a qualified Opportunity Fund, providing the most upside to those who hold their investment for 10 years or more.
An investor’s available after-tax funds compare under different scenarios, assuming various holding periods, annual investment appreciation of 7%, and a long-term capital gains tax rate of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%).
For example, after 10 years an investor will see an additional $44 for every $100 of capital gains reinvested into an Opportunity Fund in 2018 -compared to an equivalent investment in a more traditional stock portfolio generating the same annual appreciation.
In fact, in Morgan Stanley's hypothetical- the Opportunity Fund produces a 52% higher return after 10 years on the original $100 invested, or about 4.3% a year annualized over the 10-year period. In all cases the FMV (Fair Market Value) step-up in year 10 provides a larger relative return boost, an effect that grows with higher pretax returns.
Example #1:
Investor holds their Opportunity Fund stake for 10 years.
Susie has $100 of unrealized capital gains in her stock portfolio. She decides in 2018 to reinvest those gains into an O-Fund that invests in distressed areas of her home state, and she holds that investment for 10 years. Susie is able to defer the tax she owes on her original $100 of capital gains until 2026. Further, the basis is increased by 15% (effectively reducing her $100 of taxable capital gains to $85). Thus, she will owe $20 (23.8% of $85) of tax on her original capital gains when the bill finally comes due. In addition, since she holds her O-Fund investment for at least 10 years, she owes no capital gains tax on its appreciation. Assuming that her O-Fund investment grows 7% annually, the after-tax value of her original $100 investment in 2028 is $176. Susie has enjoyed a 5.8% effective annual return, compared to the 2.8% an equivalent non-O-Fund investment would have delivered.
Total tax bill in 2028: $20
After-tax value of investment in 2028: $176
Effective after-tax annual return on $100 capital gain in 2018: 5.8%
Example #2:
Investor holds their Opportunity Fund stake for 7 years.
As in Example 1, in 2018 Susie rolls over $100 of capital gains into an O-Fund. She holds the investment for 7 years, selling in 2025. As in Example 1, she temporarily defers the tax she owes on her original capital gains and steps-up her basis by 15%, so that in 2025 she will owe $20 (23.8% of $85) of tax on her original capital gains. Unlike Example 1, however, Susie will owe capital gains tax on the appreciation of her O-Fund investment, since she holds the investment for less than 10 years. Assuming that her O-Fund investment grows 7% annually, in 2025 Susie will owe $15 (23.8% of $61) of tax on the O-Fund investment’s capital gain. Susie did not take full advantage of the Opportunity Zone program but nevertheless received a 3.3% effective annual return compared to the 1.5% an equivalent non-O-Fund investment would have delivered.
Total tax bill in 2025: $35
After-tax value of investment in 2025: $126
Effective after-tax annual return on $100 capital gain in 2018: 3.3%
Example #3:
Investor holds their Opportunity Fund stake for 5 years.
As in Example 1, in 2018 Susie rolls over $100 of capital gains into an O-Fund. She holds the investment for 5 years, selling in 2023. As in Example 1, she can temporarily defer the tax she owes on her original capital gains, but her step-up in basis is only 10%, so that in 2023 she will owe $21 (23.8% of $90) of tax on her original capital gains. As in Example 2, Susie enjoys no exemption from capital gains tax on the appreciation of her O-Fund investment, since she holds the investment for less than 10 years. Assuming that her O-Fund investment grows 7% annually, in 2023 Susie will owe $10 (23.8% of $40) of tax on the O-Fund investment’s capital gain. Susie did not take full advantage of the Opportunity Zone program but nevertheless received a 1.8% effective annual return on her initial capital gains compared to the -0.1% effective annual return an equivalent non-O-Fund investment would have delivered
Total tax bill in 2023: $31
After-tax value of investment in 2023: $109
Effective after-tax annual return on $100 capital gain in 2018: 1.8%
It takes 5 years for a standard investment to recoup the 23.8% capital gains taxes paid in 2019.
As shown above the Additional Gains associated with a Qualified Opportunity Zone Investment compared to a similar return from a traditional investment is significant.
FAQ's from IRS
FAQ's from the US Treasury
Mapping tools for locating designated opportunity zones
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