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The Once In A Lifetime Tax Reduction Strategy: An Update on Opportunity Zones from an Investor’s Perspective

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There are lots of Opportunity Zone investments that are starting to hit the market. In fact, you may have even been approached by one or more of these groups asking you to invest. As the potential benefits become more widely known and as the IRS and Treasury provide additional clarity around some of the previously uncertain parts of the law, developers, investment managers, and many others are gathering to take advantage of the growing wave of interest in investing in Opportunity Zones. In this article we are going to briefly review the basics of Opportunity Zones, provide an update based on the regulations and guidance to date, and look into our crystal ball to talk about where we might go from here.

The Basics

Opportunity Zones are low income census tracts designated by the Governor of each state. Qualified investment of recently recognized capital gains into these areas provides three potential tax benefits to investors – the temporary deferral of tax on the capital gain, a permanent elimination of tax on up to 15% of the “original” gain, and no tax on future appreciation of the money invested.

Diving into a little more detail on each benefit, if realized capital gains are reinvested into a Qualified Opportunity Fund (QOF) within 180 days, the tax on these original capital gains is deferred until the earlier of when the QOF investment is sold or December 31st 2026.

If the QOF investment is held for 5 years before the tax comes due, then the taxable amount of the original gain is reduced by 10%. If the QOF investment is held for 7 years before the tax on the original gain is due, then investors get an additional 5% break. This means a potential 15% permanent exclusion is available for capital gains invested before December 31, 2019 and held through December 31, 2026.

If the QOF investment is held for 10 years or more, investors can avoid tax on all appreciation of the investment over the original amount invested. Please note, this only applies to qualifying capital gains that are invested in QOFs, not to any additional money invested – no capital gains, no tax breaks.

Regulatory Updates

Above was a very brief overview of a very complex and technical tax provision. And as with most things about taxes, the nitty-gritty is far more complex. Opportunity Zones are no exception and the tax code section as written left more questions than it provided answers. Proposed regulations issued in the middle of October provided clarity on certain areas, and most of the guidance is very friendly to taxpayers.

First, what kind of gains are eligible for deferral? The code section was very unclear about this, but the proposed regulations say that anything taxed as a capital gain is eligible for deferral.   Practically, this means short-term and long-term capital gains, net Sec. 1231 gain (generally gain from the sale of non-inventory assets used in a business), and Sec. 1250 unrecaptured gain (straight-line depreciation on a building). Not included are any ordinary gains, or Sec. 1245 and Sec. 1250 recapture (accelerated depreciation on assets).

Next, when does the 180-day clock start ticking for reinvestment? If someone owned stock and sold it, that’s pretty straight-forward. The clock starts ticking on the day of sale. But what if you were a partner in an LLC or an S-corporation and the entity sold something that generated a capital gain; now when does the clock start? The regulations are very friendly to taxpayers here and allow them to pick one of two different dates. The clock can either start on the date that the business sold the assets or on Dec. 31st of the year of the sale.

Finally, the regulations state that taxpayers may claim the 10-year, no tax on future appreciation tax benefit through the end of 2048. This again is friendly to taxpayers as it allows ample time to plan an exit from a QOF investment, and should avoid situations where someone is selling out of the QOF at an inopportune time just to take advantage of the tax savings.

The Future(?)

So where do we go from here? There are still many uncertainties out there around Opportunity Zones to the point of hindering the creation of Qualifying Opportunity Funds and the investment of capital.   As of the time of writing this article, we are expecting two additional sets of regulations related to Opportunity Zones. One was expected in December of 2018, but did not materialize. The other is expected in Q1 of 2019. Once clarity and certainty are provided, expect to see a flood of investment into this area. We believe early investors are going to get the best returns, both in terms of tax benefits due to the 10%/15% gain elimination, as well as getting first choice of the properties. As some QOFs can be setup around the investment in a single asset, proper due diligence is going to be critical. Despite the uncertainties, we view Opportunity Zones as a unique opportunity (sorry) to defer and avoid taxes. We welcome the chance to speak with you if you have questions.