The Tax Benefits of Opportunity Zones
- Opportunity zones are a new tax benefit, established by the Tax Cuts and Jobs Act of 2017, designed to spur investment in economically distressed communities.
- The tax benefits are two-fold: taxes owed on capital gains can be deferred, and in some cases reduced, if the gains are reinvested in an opportunity zone fund; and the gains on opportunity zone investments held at least 10 years are tax free.
- Investments in an opportunity zone are subject to many rules and restrictions, most of which are in two sets of proposed Treasury Department regulations.
Opportunity zones are a tax benefit created by the Tax Cuts and Jobs Act of 2017 to spur investment in economically distressed communities. In exchange for qualified investments in specific places, a taxpayer may defer and reduce taxes owed on capital gains and earn tax-free capital gains for opportunity zone investments held at least 10 years.
TAXING LONG-TERM CAPITAL GAINS – A REVIEW
Long-term capital gains – the profit earned on the sale of an asset held longer than a year – are taxed at 0%, 15%, or 20%, depending on a taxpayer’s income. On top of the capital gains tax, individuals with taxable income above $200,000 – or $250,000 for married households filing jointly – are subject to an additional 3.8% tax on their net investment income.
In general, an investor with capital gain income is expected to pay the tax in the year the gain is realized. An investor who purchases equity shares in a publicly traded company for $1 million and then sells those shares two years later for $1.5 million would have a taxable gain of $500,000 and would owe the IRS $119,000 in capital gains taxes in the year sold.
CALCULATING THE TAX BENEFIT OF AN OPPORTUNITY ZONE INVESTMENT
In the example above, investing the $500,000 capital gain from the traditional asset in a qualified opportunity zone would allow the investor to defer and reduce the $119,000 tax owed. The investor could potentially earn additional capital gains tax-free, depending on how long the opportunity zone investment is held.
Investments held at least five years receive a cost basis step-up equal to 10% of the capital gain;
Investments held at least seven years receive an additional basis step-up equal to 5% of the capital gain; and
Capital gains from the opportunity zone investment are tax free if the investment is held at least 10 years.
The table below illustrates the tax benefits of investing proceeds from the sale of a traditional asset in an opportunity zone.
Calculating the Tax Benefits of a Qualified Opportunity Zone Investment
In each case, by investing in an opportunity zone the investor pays less tax and pays it much later in cheaper dollars because of inflation. In addition, there is a significant tax benefit for investments held at least 10 years: the post-investment gains in the opportunity zone asset are tax free.
SPECIAL RULES APPLY
The tax benefits of investing in an opportunity zone are subject to many rules and restrictions, most of which are enumerated in two sets of Treasury Department proposed regulations issued October 2018 and May 2019. There are, however, some universal basics:
In general, capital gains from the sale of a traditional asset must be reinvested in a qualified opportunity zone within 180 days of the date of the sale. Proposed Treasury regulations provide additional flexibility for certain gains.
Deferred tax on the reinvested capital gain is due on disposition of the opportunity zone asset or December 31, 2026, whichever is earlier.
The year seven step-up in basis creates a sense of urgency. For investments made after the end of this year, it will be impossible to achieve the seven-year holding period prior to the due date for deferred taxes on the original capital gain, December 31, 2026.
Qualifying capital gains are not reinvested directly in a qualified opportunity zone property but rather through a qualified “opportunity fund.”
Opportunity funds cannot invest in golf courses, private clubs, massage parlors, hot tub facilities, tanning facilities, racetracks, casinos, or liquor stores, and they cannot invest in other opportunity funds.
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