Is an Opportunity Zone Investment Right for You?
June 6, 2019 | Robin Shields
Tax reform signed into law at the end of 2017 created a new tax advantaged investment opportunity with the establishment of Federal Opportunity Zones (“zones”). Zones have been designated throughout the country including the District of Columbia and the U.S. territories.
The creation of the zones is intended to spur economic development and job creation in low-income and distressed communities by providing federal tax benefits to investors who re-invest realized capital gains into Qualified Opportunity Funds (“QOFs”). These QOFs must in turn invest in assets or businesses located within these designated zones.
A QOF is an investment vehicle organized, as either a corporation or partnership, with the purpose of investing in a zone. Single-member LLCs do not qualify. QOFs must have 90% of its fund assets invested in the zones. A QOF must also self-certify with the filing of its federal income tax return that it qualifies as an applicable investment vehicle. Taxpayers cannot invest in opportunity zone property directly as all investments must be through a QOF.
Taxpayers can defer and potentially reduce capital gains tax owed from realized transactions by investing the gain in QOFs. Generally, the capital gain must stem from a sale or exchange with an unrelated party. The gain must then be re-invested into a QOF within 180 days from the sale date or if the gain occurred in a partnership or S Corporation, then potentially 180 days from December 31st of the sale year. Investing other money alongside the capital gain is permissible, but only the capital gain portion of the investment will give rise to tax benefits. Taxpayers must also make an election with their timely filed federal income tax return to defer the gain that has been invested in a QOF.
Federal Tax Benefits
Deferral of Tax
Generally, a taxpayer can defer tax on capital gains invested in a QOF until divestiture from the QOF or until December 31, 2026, whichever is earlier. The character of the capital gain (short-term or long- term) survives the investment in the QOF.
Reduction in Tax
If the QOF investment is held for 5+ years, the deferred capital gain included in gross income is reduced by 10%. If the QOF investment is held for 7+ years, the deferred capital gain included in gross income is reduced by 15%.
Exclusion from Tax
Also, as an added tax benefit if the QOF investment is held 10+ years and then sold, the taxpayer would pay no tax on the appreciation of the fund investment above the original capital gain. That is a huge potential tax benefit.
State Tax Implications
Typically, the starting point for determining state taxable income is federal taxable income which is based on the Internal Revenue Code (IRC). States have differing approaches in conforming to the IRC so state tax implications and opportunities should be factored into any investment decision.
Many taxpayers and QOF managers have been waiting for guidance from the IRS before completing any transactions and now most of that guidance is in and is taxpayer friendly. Therefore, activity in these QOFs is starting to heat up around the country.
If you have built-in capital gains or if you have had a recent transaction that resulted in a capital gain, please reach out to an HHM professional to discuss the potential federal tax benefits that a long-term investment in a QOF may provide.