Opportunity zones were included in the 2017 Tax Cuts and Jobs Act and provide three major tax breaks for real estate investors who use a qualified opportunity fund: temporary capital gains deferral, basis step-up of previous gains invested, and a permanent exclusion on long-term holdings of 10 years or more.
The opportunity zone (OZ) idea is to spur economic development in areas deemed undercapitalized, low-income, and in need of investment. Since the final enabling guidance wasn't put into place until late 2019, just before the coronavirus pandemic hit, it could be a while before the impact of opportunity zone investment is known.
But billions of dollars already have been committed in the more than 8,700 census tracts - about one-eighth of America - that are included in the opportunity zone program and their potential as a tax break win-win for real estate investors and distressed communities will generate attention as the concept matures.
Substantial and long-lasting investments and tax breaks
Each opportunity zone designation originated with a governor (or the mayor of Washington, D.C.) nominating their designated opportunity zones. The investments in them are done through qualified opportunity zone funds (QOFs). A qualified opportunity zone fund, as defined by the IRS, is an "investment vehicle that files either a partnership or corporate federal income tax return and is organized for the purpose of investing in QOZ (qualified opportunity zone) property".
Existing and startup businesses can be funded in that eligible census tract, as well as residential, commercial, and industrial real estate. To earn the tax benefit, the properties also must be "substantially improved" as a result of the investment, requiring expenditures from the QOF, but the tax advantages to the qualified investor from the reduced capital gain can be substantial and long-lasting, and they can used by individuals or corporations of various kinds.
The three major breaks
Here's a quick list of the three major breaks for opportunity fund investment, courtesy of the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution:
- Temporary deferral of taxes on previously earned capital gains. Investors can place existing assets with the original capital gain into QOFs. Those existing capital gains are not taxed until the end of 2026 or when the asset is disposed of.
- Basis step-up of previously earned capital gains invested. For capital gains placed in QOFs for at least five years, investors' basis on the original investment increases by 10%. If invested for at least seven years, investors' basis on the original investment increases by 15%.
- Permanent exclusion of taxable income on new gains. For investments held for at least 10 years, investors pay no taxes on any capital gains produced through their investment in QOFs.
Now, let's take a bit deeper look. After this, if you want to learn more about OZ investment, the IRS maintains a robust FAQ on OZs and QOFs, including who's eligible to join the ranks of opportunity zone investors (nearly anyone) and where the zones are (nearly everywhere).
Here, we'll focus on each tax incentive itself.
Types of Gains Eligible
The IRS says both capital gains and qualified Section 1231 gains are eligible for deferral through investments this year in QOFs, as long as they are recognized in your federal returns by Jan. 1, 2027. Those no-longer unrealized capital gains can come from stocks, real estate and other investments.
The Temporary Deferral
This is the shorter of the deferral periods. (In fact, as we'll see below, the longer one is permanent.) The temporary deferral holds that you can defer from including in your gross income a gain from the sale or exchange of any property to an unrelated person if it's invested in a QOF during the 180-day period beginning on the date of the sale or exchange.
So, when do you have to include it? The year when the investment is sold or exchanged or Dec. 31, 2027, whichever comes first, again, if you make the investment in the 2020 tax year.
The Step-Up in Basis
You benefit from an increase in the basis for capital gains reinvested in a QOF depending on how long you hold that deferred gain. It begins with a 10% increase if you, the investor, hold that investment for at least five years, and by 15% if you hold it for at least seven years. That means that 15% of your original investment would be shielded from taxation.
So, for example, if you put $1 million in capital gains in a QOF by the end of 2020, your basis for capital gains taxes would be reduced by $100,000 at the end of 2025 or $150,000 by the end of 2027.
The Permanent Exclusion
This is the most powerful of the tax benefits, and also takes the most commitment since it's targeted at long-term capital gains. Hold on to that QOF investment for at least 10 years, and any gains it makes in value after your investment in it are permanently excluded from the capital gains tax.
Your tax basis for that investment will be the fair market value on the date it's sold or exchanged, and you have to make what IRS calls an "affirmative election" to leverage this tax break. That means you have to choose it, like when you choose to enroll in a 401(k) or similar plan. It's not done for you by the IRS.
So, for example, if that $1 million you invested at the end of 2020 becomes worth $1.5 million in 2030, that $500,000 in appreciation is yours tax-free.
There are a lot of other rules involved in the opportunity zones program and opportunity zone fund investment.
The 180-Day Investment Period
The IRS gives you 180 days to invest an eligible gain in a QOF. The first day of the 180-day period is the date the gain would be recognized for federal income tax purposes (unless you elected to defer recognizing that gain).
Because of the difficulties created in executing real estate transactions, the IRS granted relief on that investment period. Now, if that 180th day to invest in a QOF is on or after April 1, 2020, and before Dec. 31, 2020, you have until Dec. 31, 2020, to invest that gain. Similar relief was extended for the substantial improvements requirement.
Improving properties, and thus their communities, is a core idea of the opportunity zone program in the first place. The IRS requires that the QOF must "substantially improve" that real estate.
The agency considers a threshold to be doubling the adjusted basis in the property after purchase and during any 30-month period that they hold their qualified opportunity zone property.
"The additions to basis must exceed the adjusted basis in the property at the beginning of such 30-month period. Land is excluded from the adjusted basis calculations," says a blog from the Withum advisory and accounting firm.
The firm's post includes this example: "QOF A purchased a vacant office building located in a qualified opportunity zone. The QOF purchased the building for $1 million. Of that, 60% is allocated to the building value ($600,000) and 40% is allocated to the land value ($400,000). Therefore, during any 30-month period, QOF A must substantially improve the property by increasing the adjusted basis in the building by whatever the adjusted basis is at the beginning of the 30-month period.
"So, for the first 30-month period after the purchase, an additional $600,000 (the amount allocated to the building at the time of purchase) of substantial improvements are necessary. A year after purchasing the building, QOF A spends $750,000 and 15 months to redevelop the building and build out spaces for incoming tenants, thereby satisfying the substantial improvement clause."
Note: there are other rules around property improvements as OZ investments, including FHA rehab limits, for starters. Opportunity zones in some eligible census tracts also may offer their own incentives, such as a separate tax credit for affordable housing.
Do your due diligence
IRS rules can be expected to change over time, regardless of the pandemic, as the opportunity zone tax breaks mature, and regulators and lawmakers respond to the impact.
This June 5, 2020, article in the Journal of Accountancy explains in detail the relaxation of OZ rules in response to the pandemic. It's a good place to start your research about the tax benefits.
Bottom line: Investing in OZs is an emerging discipline and the business and tax implications are already complex and getting more so. Be sure to discuss the ramifications and possibilities with a qualified tax attorney and investment advisor.
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