One of the perhaps lesser known provisions of the Tax Cuts and Jobs Act of 2017, which could be very beneficial to real estate investors and high net worth individuals, was the establishment of Qualified Opportunity Zones. Under the new law, investment in such zones could provide significant tax deferral opportunities.
The IRS defines a Qualified Opportunity Zone as “an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation authority to the Internal Revenue Service.”
The Opportunity Zones were created to spur economic development and create jobs in distressed communities, by offering tax savings to potential investors.
How Does It Work?
Investment in a Qualified Opportunity Fund could result in tax deferral/savings in several ways.
1. Deferral of capital gain recognition
The gain realized from the sale of a capital asset to an unrelated party can be deferred, if within 180 days from the sales date, the seller completes an investment in a Qualified Opportunity Fund and submits the appropriate deferral election. At this time there are no limits on the size of the investment. The deferral period would end and thus the capital gain would be subject to tax in 2026.
2. Possible reduction of the deferred capital gain
If the investment is held for 5 years, an adjustment equal to 10% of the deferred capital gain would be added to basis. If the investment is held for an additional 2 years, an additional adjustment equal to 5% of the deferred capital gain would be added to basis. Either way, the maximum is a 15% basis adjustment. In order to receive the full 15% basis adjustment, the investment would have to be completed by 12/31/2019 as the deferral period ends 12/31/2026.
3. Possible permanent exclusion from tax of the appreciation in the Qualified Opportunity Zone Fund
Any post-acquisition appreciation on investments in Qualified Opportunity Zone Funds that are held for at least ten years, are excluded from gross income at the time of sale.
An Example of a Capital Gains Investment in a Qualified Opportunity Zone
The Qualified Opportunity Zones have not been around a long time, only since April 2018. Thus far, 18 states have identified qualifying zones. There remain many questions as to exactly how tax deferred investment in the zones will work in practice, but according to what we do know from the Treasury Department, we have created the following hypothetical example. Naturally each case will be unique. This should be taken merely as an example of tax deferred savings that could be realized when investing in a Qualified Opportunity Zone.
Real estate investor X (REX), sells property and realizes a gain of $1 million on Dec. 1, 2019. On Dec. 31, 2019 (i.e., a date within the 180-day period beginning on Dec. 1, 2019), REX invests all of the $1 million gain into a Qualified Opportunity Fund. REX makes the temporary deferral election and does not include the $1 million of realized gain in his gross income for the 2019 tax year. REX has a zero basis in the investment ($0 basis in gain). If REX holds the investment for five years, his basis in the investment is increased by $100,000 (10% of the deferred gain of $1 million). The basis could further increase by 5% if the investment is held for at least seven years. The deferral period would end in 2026 and thus the $850,000 capital gain would be subject to tax in 2026. If the Qualified Opportunity Fund property is sold for $5,000,000 after 10 years the $4,000,000 gain is tax free.
Details on a Qualified Opportunity Fund
- The Qualified Opportunity Fund must hold at least 90% of its investments in Qualified Opportunity Zone Property.
- Qualified Opportunity Zone Property is stock, partnership interest, or business property used in a Qualified Opportunity Zone Business.
- A Qualified Opportunity Zone Business is a business in which substantially all tangible property (owned or leased) is a in a Qualified Opportunity Zone.
The IRS will issue forms and instructions that will allow taxpayers to self-certify as a Qualified Opportunity Fund. The IRS has provided a list of Frequently Asked Questions about Opportunity Zones.
How MBAF Can Help
This is just one example of how creating a Qualified Opportunity Zone Fund could provide significant tax savings on returns from capital investments. There are many provisions within the Tax Cuts and Jobs Act of 2017, like this one, which were specifically created to drive economic growth by offering various tax incentives for investors. Our experts are familiar with all of the opportunities created by the new law, and can help you maximize your return on investments, while minimizing your tax obligations.
Understanding the opportunities and tax savings created by can be the Tax Cuts and Jobs Act of 2017 can be quite complex. If you would like to benefit from our expertise in these areas, or if you have further questions on this Advisory, do not hesitate to contact our Real Estate Specialists, or call us at 1-800-239-1474.