Tax-free gains! Sounds too good to be true, right? Not anymore.
The Tax Cuts and Jobs Act of 2017, signed into law in December 2017 provided for a new section of tax code that relates to Opportunity Zones (O-Zones). This provision allows a taxpayer to defer capital gains by reinvesting the gain into a Qualified Opportunity Fund (O-Fund). Then, even more appealing, any gain on the reinvestment can escape tax forever. Here’s how it works:
A taxpayer who experiences a capital gain, whether from a sale of marketable securities, a business, real estate, etc., can reinvest the gain portion of that sale into an O-Fund within 180 days of the date of that realized gain. The tax on the reinvested portion of the original gain is deferred until the earlier of 1) the sale of the O-Fund investment, or 2) December 31, 2026. If the reinvestment in the O-Fund is held at least 5 years, there will be a 10% basis step up, while if the reinvestment is held at least 7 years, the basis step up will be 15%, thereby exempting tax on a portion of the capital gain realized on the original sale. Furthermore, If the reinvestment in the O-Fund is held at least 10 years, any gain on the O-Fund reinvestment escapes tax forever.
The O-Fund must invest in Qualified Opportunity Zone Property. This can be the corporate stock or partnership units of a business, or business use property (such as real estate), as long as substantially all of the property is located in a Qualified Opportunity Zone. If the property is not the original use of the O-Fund, substantial improvements must be made to the property. Therefore, most real estate then must be substantially developed or redeveloped; essentially the improvements made to the property have to exceed the original cost basis of the property at acquisition. The substantial improvements need to be made within 30 months after the acquisition of the property. The entire redevelopment doesn’t need to be done within the 30 month restriction, but the dollars spent on the redevelopment needs to exceed the original cost basis of the property within 30 months of the acquisition.
There are different ways to take advantage of this deferral/exclusion. You can start or buy a business in an O-Zone, or you can invest in and redevelop real estate in an O-Zone. For the most part, we believe this will be used more frequently as a real estate play. It will allow capital to flow easier to projects in historically less appealing geographic areas.
Each state has nominated different zones, which are census tracts, that qualify to be labeled as Qualified Opportunity Zones. Check your states website for the tracts nominated by your Governor. These zones are designated as low income communities and met certain criteria of median family income to qualify. However, up to 25% of the tracts can be adjacent to tracts that meet the criteria mentioned, but don’t themselves meet the criteria. We’ve discussed these tracts with many developers/investors who believe there are parts of the O-Zones that were already next to be developed anyway, even before this law was passed. These are now even more appealing to developers now that capital will flow more freely, and likely a bit cheaper, for projects in these zones.
- A family office realizes a $10 million capital gain in June 2018 and during the same month invests the entire capital gain in a newly created O-Fund. In September 2018, the O-Fund buys land and builds a retail shopping center in an O-Zone. If the O-Fund is held at least 5 years, the taxable portion of the original $10 million capital gain would be reduced to $9 million. If the O-Fund is held at least 7 years, the taxable portion of the original $10 million capital gain would be reduced to only $8.5 million.
- A family office realizes a $10 million capital gain in June 2018 and during the same month invests the entire capital gain in a newly created O-Fund. In September 2018, the O-Fund buys land and builds a retail shopping center in an O-Zone. The O-Fund is held 11 years. Therefore, the tax due on the $8.5 million taxable portion of the $10 million original capital gain is due in April 2027 for calendar year filers. In year 11, the O-Fund is sold for $14 million. Since the O-Fund was held for over 10 years, the O-Fund will get a step-up in basis to the fair market value of the property and therefore eliminate any tax burden on the $4 million of appreciation.
The Treasury has yet to publish Regulations regarding Opportunity Zones and Opportunity Funds. This delay isn’t slowing down many investors/developers from forging ahead – likely on projects that were already in the hopper, but now just so happen to fall in an O-Zone. Hopefully others will follow once development in these areas advance.
We must note that at the time this article was written, the Treasury had not yet issued Regulations regarding this section of the Internal Revenue Code. Therefore, provisions in this law, or interpretations, are subject to change. Furthermore, many states have not yet addressed whether or not they will follow the federal law with regards to O-Zones. Contact for up-to-date information regarding this law as regulations are proposed.