Many changes under the Tax Cuts & Jobs Act are widely known. However, one change within the Act that presents a way to reduce or eliminate capital gain income often goes unnoticed – Opportunity Zones.
What are Opportunity Zones?
The purpose of Opportunity Zones is to promote economic growth and recovery in low-income communities. This is done through tax incentives that encourage private investment of unrealized capital gains. Investments in Opportunity Zones are done through Qualified Opportunity Funds. An Opportunity Fund is an intermediary that aggregates private funds and invests the funds in Opportunity Zone assets. Tax incentives associated with investment are meant to drive long-term investments to parts of America that continue to struggle with high poverty and low growth. Many people look at this as an attempt to recover from the Great Recession of 2008, which has yet to happen in many parts of the country.
The implementation of Opportunity Zones is a market-driven project, meaning there will be no government interference with the investments. Instead, governors have sole decision-making over where the Opportunity Zones will be located. The process involves:
- Each state may nominate a minimum of 25 total eligible census tracts, but no more than 25% of the total number of eligible census tracts within the state.
- Nomination must be made by the governor no later than April 20, 2018.
- When finalized, the U.S. Department of the Treasury will approve the nominated census tracts and administer the Opportunity Zone Program.
Opportunity Funds must be from a corporation or partnership that invests at least 90% of their assets in Opportunity Zones. The Opportunity Funds can invest in a singular investment or many investments in many Opportunity Zones. Types of investments in Opportunity Zones include:
- Equity investments into businesses and real estate
- Stock in a domestic corporation that is an Opportunity Zone business
- Capital or profits interest in a domestic partnership that is an Opportunity Zone business
- Tangible Property used in a trade or business of the Opportunity Fund that substantially improves the property
To be considered an Opportunity Zone business, at least 50% of the gross income earned by the business must be from the active conduct of a business in an Opportunity Zone, substantially all of the tangible assets must be used in Opportunity Zone, and the business can hold a limited amount of investment assets. “Sin” businesses such as casinos do not qualify for Opportunity Zone benefits.
What are the tax benefits?
The Opportunity Zones program offers three types of incentives for investing in low-income communities through a Qualified Opportunity Fund.
- Deferral of Gain: To defer a capital gain, a taxpayer must invest proceeds from the sale of an investment within 180 days from the date of sale in an amount equal to the gain to be deferred. Any recognition of gain would occur upon the exit of the Opportunity Fund or 12/31/26, whichever happens first.
- Step-Up in Basis:
- If the investment in the Opportunity Fund is held for 5 years, the taxpayer is awarded a basis increase equal to 10% of the deferred gain. This reduces the taxable gain needed to be recognized upon exit of the investment or 12/31/26.
- If the investment in the Opportunity Fund is held for 7 years, the taxpayer is awarded a basis increase equal to 15% of the deferred gain.
- Permanent Exclusion: If the investment in Opportunity Fund is held for 10 years, the taxpayer does not need to recognize any capital gain income on the appreciation of the Opportunity Fund investment.
The Opportunity Zones program has the potential to have a very positive impact on low-income communities as well as investors’ tax returns. Deferring or eliminating gains that would normally be taxable has the ability to save significant tax dollars. It is important to consider your overall tax situation, cash flow, and the viability of potential Opportunity Zone Funds when determining whether this would be an investment that makes sense for you.
To learn more about how the Tax Cuts and Jobs Act may impact real estate development contact a member of our real estate team today.