Opportunity knocks: Congress authorizes tax-free profits for investors in qualified opportunity zones
Columbus Business First June 1, 2019
Created by the Tax Cuts and Jobs Act, over 8,700 tracts of land across the county have been designated as "qualified opportunity zones,” providing new and compelling tax incentives for rethinking where and how to do business.
Normally, a profit resulting from the sale of an asset is taxed at a maximum capital gains rate of 20%. Now, Congress gives taxpayers the option of reinvesting that profit into opportunity zones in exchange for deferral of the tax until year-end 2026. If invested for seven years, then the taxpayer-investor receives a 15% tax break on the amount deferred. If invested for 10 years, then the sale of that investment will be treated 100% tax-free.
Opportunity zones were designed to incentivize the reinvestment of an estimated $6 trillion in private, unrealized capital gains into designated areas that have failed to recover from the Great Recession.
Investing in an opportunity zone
Consider the following hypothetical that highlights the basic timing rules and tax mechanics. On July 1, 2019, Audrey sells several stocks, an investment property, and some bitcoin for a $1 million profit. Subject to the 20% long-term capital gains rate, Audrey's tax liability is $200,000.
Rather than pay this tax to the IRS on her 2019 return, Audrey forms a multi-member LLC as a qualified opportunity fund and reinvests the $1 million profit into her fund within 180 days of the sale. Audrey then must choose between investing in another property or starting a new business within an opportunity zone. Within another 180 days, she decides to use the fund to purchase, renovate, and lease-up an apartment building located within an opportunity zone.
On July 1, 2024, Audrey elects to receive a 10% step-up in basis on her $1 million investment because she has held the investment for five years.
On July 1, 2026, Audrey makes another election to receive an additional 5% step-up in basis because she has held the investment for seven years.
On December 31, 2026, Audrey's deferred capital gains tax bill becomes due and payable, but since she has reduced her deferred capital gain from $1 million to $850,000, she has also reduced her tax liability from $200,000 in 2019 to $170,000 in 2026 (which equals 15% of $850,000).
In 2029, on the tenth anniversary of her investment, Audrey becomes eligible for a tax-free exit. If Audrey sells the property for $4 million, then she can elect to step up her basis in the fund to an amount equal to the sale price, resulting in no tax on her $3 million profit.
In this simplified example, Audrey has maximized the opportunity zone tax benefits.
Strategic planning considerations
As of April 2019, the IRS has provided sufficient guidance for entrepreneurs to form opportunity zone business strategies with their professional advisors. Since the tax benefits begin phasing out by the end of this year, however, time is of the essence.
The amount of tax deferred becomes due and payable by year's-end 2026, so taxpayer-investors must invest before the end of this year to achieve the full 15% reduction provided by the seven-year investment timeline. The 10% reduction phases out two years later, and temporary deferral is gone by year-end 2026. However, the most enticing incentive — the tax-free exit — will remain available so long as the investment is made before the tenth anniversary of the opportunity zone's designation, in all cases by year-end 2028.
Furthermore, the IRS requires investment properties to meet more criteria than merely being located in an opportunity zone. In addition to the timing rules, there are restrictions on what type of gains and property are eligible for investment, and qualifiers on the creation and continued qualification of an opportunity zone property or fund. Pooling investments would certainly have a compounding effect on returns, but it would also implicate compliance with federal and state securities laws.
Opportunity zones present an immediate business finance and tax planning opportunity for savvy entrepreneurs to evaluate with their professional advisors.
An interactive map of national qualified opportunity zones is available online at the Treasury Department’s website, cdfifund.gov/Pages/Opportunity-Zones.aspx.
This article originally appeared in Columbus Business First.