News & Events
Tax Benefits from Investments in Opportunity Zones
February 25, 2019
Tax Benefits from Investments in Opportunity Zones
The Tax Cuts and Jobs Act of 2017 created a significant federal income tax break for individuals who recognize capital gains and elect to reinvest them in economically distressed regions. The tax break is threefold. First, payment of tax on the capital gain is deferred. Second, the amount of gain subject to tax will be reduced by 10% if the reinvestment is held for 5 years and by another 5% if the reinvestment is held for 7 years, for a total reduction of 15%. Third, any gain ultimately recognized on the reinvestment will never be subject to tax if the reinvestment is held for at least 10 years.
Capital Gain Reinvestment in Qualified Opportunity Zone
In order to benefit from this tax break, an individual must recognize a capital gain from the sale of property to an unrelated third party before January 1, 2027. The capital gain can be either short tern or long term gain. In addition, it can be gain from the sale of a capital asset, such as a stock, bond or parcel of real estate, or gain from the sale of property used in a business, such as plant and equipment.
Once gain is recognized, the investor must reinvest it in an opportunity zone fund within 180 days. An opportunity zone fund (“OZFund”) is an entity that invests in census tracts whose residents have lower than average incomes and higher than average poverty rates (so-called “low income communities”) that a state designates as qualified opportunity zones. There are now qualified opportunity zones in every state, as well as in the District of Columbia, Puerto Rico, the U.S. Virgin Islands and certain other U.S. territories. Census tracts contiguous to a low income community tract can, within certain limits, be designated as qualified opportunity zones even though they are not financially distressed and do not qualify as low income communities.
Many qualified opportunity zones may be attractive from an investment point of view. For example, a census tract near an airport may be a low income community because higher income individuals choose to live away from the airport whereas lower income individuals cannot do so, and yet the area may be ideally suited for a hotel, office park or similar use. In addition, a non-financially distressed tract that is designated as an opportunity zone may be attractive.
Tax Treatment of Reinvested Capital Gain
If the capital gain is timely reinvested, the individual will not have to pay tax on the gain until the earlier of (i) the date the interest in the OZFund is sold or exchanged, or (ii) December 31, 2026. The 2026 taxation date exists because many of the provisions of the Tax Cuts and Jobs Act “sunset” after 2025 for budgetary reasons.
In addition to the delayed date for payment of tax, the amount of taxable gain will be reduced by 10% if the OZFund interest is held for 5 years and by another 5% if the interest is held for 7 years. As a result, if an individual recognizes a capital gain, reinvests it in an OZFund in 2019, and holds it until at least 2027, the gain subject to tax will be reduced by 10% in 2024 and by another 5% in 2026, the year in which the tax must be paid.
It is not clear how the 10% and 5% reductions will apply to investments in an OZFund after 2019 since in these cases the 5 and 7 year holding period requirements cannot be met until after 2026, the last possible year in which the tax must be paid. The Internal Revenue Service has not yet provided guidance on this issue, but it is possible that investments after 2019 will not benefit from these reductions.
Tax Treatment of Investment in OZFund
The favorable treatment of gain recognized on the OZFund investment itself is potentially much more valuable than the tax treatment of the initial capital gain. So long as the OZFund interest is held for at least 10 years, any gain that is recognized when the interest is ultimately sold or exchanged is completely exempt from tax. The total exemption from tax applies irrespective of how large the gain is, so this benefit can result in substantial tax savings.
Assume that an individual sells publicly traded shares in March 2019 for a short term capital gain of $100 and within 180 days invests the full $100 in an OZFund. Further assume that the individual holds the OZFund interest until 2030, at which time the interest is sold for $450. The individual will owe tax in 2026 on $85 of short term capital gain. The $350 of long-term capital gain that the individual recognizes upon sale of the OZFund interest in 2030 will not be subject to tax. If the individual sells the interest in 2028 instead of 2030, so that the 10 year holding period requirement is not met, tax will be owed on the $350 of long term capital gain. In addition, if the individual sells the interest in 2023, so that none of the holding period requirements are met, tax will be owed in 2023 on $100 of short term capital gain and $350 of long term capital gain.
Points to Keep in Mind
Several important points should be noted. First, the tax benefits of investing in an OZFund are available only to long term investors. As a result, investors with a short term time horizon are unlikely to find OZFunds attractive.
Second, an individual can choose to invest only part of a capital gain in an OZFund, although the deferral of tax will apply only to the portion so invested. In addition, an individual can choose to invest in multiple OZFunds. Whether all or only part of a capital gain in invested, there is no tracing of capital gain proceeds. As a result, an individual does not have to keep track of capital gain proceeds and invest those identical dollars in an OZFund.
Third, the deferral of tax on the original capital gain may not always work to an individual’s ultimate advantage, even if the gain is reduced by 15% due to satisfying the 7 year holding period requirement. The risk is that the tax on the deferred gain will be based on the tax rates and other rules in effect in the year it is taxed, whether that year is 2026 or an earlier year. If those rates and other rules are less advantageous than the rates and rules in effect in the year the capital gain is recognized, the individual may end up paying more tax than if tax were paid at the time the gain was recognized.
Fourth, since the most compelling tax reason to invest in a OZFund is the favorable treatment of gain recognized on the OZFund itself, rather than deferral of tax on the original gain, it behooves an individual to assess the investment potential of the OZFund, separate and apart from tax consequences. If the investment potential of an OZFund is weak, the tax benefits of investing in it are likely to be more illusory than real.
An individual recognizing capital gain from the sale of a wide variety of different type of assets may wish to consider investing some or all of that gain in an OZFund. Care must, however, be taken to comply with timing and other rules. Moreover, although the tax benefits can be significant, investment, rather than tax, considerations should predominate.
Please note that this newsletter is only a brief summary of certain of the federal rules applicable to investing in OZFunds. As a general overview, it is not intended to be a comprehensive description of OZFunds and the federal income tax consequences of investing in them, and it is not intended to constitute legal advice. Moreover, the Internal Revenue Service is still in the process of addressing various issues relating to OZFunds, and future guidance may affect the rules applicable to them and the attractiveness of investing in them. Finally, since each situation is different, an individual should invest in an OZFund only after seeking legal counsel.