Is Investment in Qualified Opportunity Zones Right for You?

As you have seen by now, there is a great deal to unpack from the 2017 Tax Cuts and Jobs Act. Most investors have experienced how the tax act impacted their personal wealth the first time they did their taxes after the law went into effect. It was certainly a gamechanger for some as people had to readjust their investment portfolio to leverage the new regulations to their advantage.

 

While most people are familiar with the tax consequences of the act, the bill had an investment facet tied into the portion of the law about creating jobs. The vision the writers of the bill had was this would be a win-win scenario for investors and for establishing new jobs in economically depressed areas of the country. What the law established were Qualified Opportunity Zones.

 

The concept behind these zones is simple. The Internal Revenue Service says, “Opportunity zones are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities.” These Qualified Opportunity Zones (QOZs) would be created in all 50 states as well in the United States’ possessions and territories. The concept is simple: investors will receive tax benefits when they invest eligible capital into one or more QOZs.  Specifically, taxpayers can defer tax on eligible capital gains by investing in a Zone and meeting a few other requirements.

 

Qualified Opportunity Zones result when a local community is selected for that designation by the state. It then has to be approved and certified by the Secretary of the U.S. Treasury who issued the delegation of this power to the IRS.  Under the law, investors may be able to defer tax on almost all capital gains they invest after December 31, 2017, through December 31, 2026.

 

A Qualified Opportunity Fund is an investment vehicle that files either a partnership or corporation federal income tax return and organized for the purpose of investing in Qualified Opportunity Zone property. For example, an LLC that chooses to be treated either as a partnership or corporation for federal tax purposes can organize as a Qualified Opportunity Fund.

 

Let’s look at the three main elements why an investor might find a QOZ advantageous:

 

  • The investor receives a temporary tax deferral for capital gains reinvested in a Qualified Opportunity Zone. It is essential to note the time constraints with this investment. The deferred gain is recognized on whatever comes first: the selling of the QOZ investment or December 31, 2026.
  • The law has a provision for a step-up in basis for capital gains reinvested in an Opportunity Fund. The basis of the original investment is increased by 10% if held by the taxpayer for at least five years. The investor can then receive an additional 5% if held for seven years. (Excludes up to 15% of the original gain from taxation.)
  • If the investment is held for at least ten years, the investor receives a permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund. The exclusion is only applicable to the gains accrued from the investment, not the original gains.

 

An investor can receive the tax benefit even if he or she does not live, work, or have a business in a Qualified Opportunity Zone. All anyone has to do is invest a recognized gain in a Qualified Opportunity Fund and elect to defer the tax on that gain. To qualify for that deferral, a person must invest in a Qualified Opportunity Fund within 180 days of realizing the capital gains, the fund must hold at least 90 percent of its assets in qualified opportunity zone property, and the investment in the Qualified Opportunity Fund must be an equity interest, not a debt interest.

 

A taxpayer can transfer property other than cash as an investment to a Qualified Opportunity Fund.  However, a transfer of non-cash property may result in only part of the investment being eligible for opportunity zone tax benefits, so that not all the taxpayer’s capital gain is able to be deferred.

 

As an example, let’s say that you sell your business. For the sake of argument, you realized a gain of $10 million on that business when you crunch all the numbers. That amount becomes subject to capital gains tax. By investing some or all that amount into a Qualified Opportunity Fund, you can temporarily avoid those taxes. As you can see, when you sell your shares in a fund, the gain you realized on the sale is protected from taxes up to a certain point if you held the investment according to the IRS statues.

 

Here is a list of the areas the Secretary of the Treasury designates as Qualified Opportunity Zones: https://www.irs.gov/pub/irs-drop/n-18-48.pdf

 

As with all investments, an investor has to look at the pros and cons of investing in a Qualified Opportunity Fund. While investing in a manner that defers taxes and even allows earning some money tax-free, talk to a financial advisor that knows about QOZ. It is obviously a new investment and not everyone is up to speed on all the details. Remember, while the deferred tax on capital gains is desirable, the decision on whether an investment is right for you should encompass more than one factor. That being said, investing in a Qualified Opportunity Fund is something you should investigate if you are about to have a significant capital gain on the sale of a business, property, or investment.