With the historic bull run in markets, many investors may seek ways to mitigate the tax impact on their appreciating assets. The Tax Cuts and Jobs Act (TCJA) has created an opportunity for investors to defer taxes on capital gains if they invest in so-called “Opportunity Zones” to improve distressed areas of the country.
What is an Opportunity Zone?
Opportunity Zones are geographic areas established by the TCJA to encourage investment in economically distressed urban and rural communities in order to build businesses and create jobs.
The law designated 8,761 areas across the United States as well as territories. The zones retain this status for 10 years.
What are the tax benefits?
- Investors may defer tax on almost any capital gain up to December 31, 2026, by making an appropriate investment in a zone, through a “Qualified Opportunity Fund” (QOF), making an election after December 21, 2017, and meeting other requirements
- A taxpayer can defer recognition of that gain until the earlier of (1) the sale or exchange of the taxpayer’s interest in the QOF, or (2) December 31, 2026
- Gains held within a QOF for five years receive a 10% exclusion on that gain, and for seven years receive a 15% exclusion on the gain
- Investors holding an Opportunity Fund for at least ten years are eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged
Example: Tax benefit of holding interest in a QOF for at least 10 years
- John sells an appreciated stock in 2018 realizing a capital gain of $200,000
- Within 180 days, he invests the $200,000 gain into a Qualified Opportunity Fund (QOF) and benefits from deferral of capital gains tax
- By the deadline of December 31, 2026, the investment within the QOF has grown from $200,000 to $300,000, which makes John eligible for a 15% exclusion on the original capital gain invested in the QOF ($200,000 x 15% = $30,000) because the investment has been held for at least seven years
- John would realize a gain of $170,000 after the 15% exclusion ($200,000 original gain invested in the QOF minus the $30,000 gain exclusion)
- John holds his interest in the QOF until 2028, at which time his investment has increased to $400,000 in value, and he decides to sell his interest
- Because he held the investment within the QOF for at least 10 years, he benefits from a step-up in cost basis to the current value of $400,000
- Overall, John sheltered $230,000 worth of investment gain from taxation ($400,000 value after 10 years minus $170,000 gain realized at December 31, 2026)
- The qualified capital gain must be invested within a QOF within 180 days of sale or exchange
- Eligible taxpayers include individuals as well as corporations, partnerships, real estate investment trusts (REITs), regulated investment companies (RICs), and other pass-through entities
- Investment in an QOF must be equity interest, and cannot be a debt instrument
- Funds must meet certain tests on percentage of assets invested within an opportunity zone
Considerations for investing
Taxpayers should consider how long they plan to hold the investment in order to benefit from excluding some of the gain from taxation. They must also consider any investment risk associated with investing in an underdeveloped area. It is important to discuss this tax strategy with a professional financial advisor and tax and legal experts who will be able to guide you in weighing the benefits and risks.
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