Deven L. Munns, Esq.
Opportunity Zones (OZ) investments were created under the recent passage of the Tax Cuts and Jobs Act (TCJA) and designed to help states jumpstart communities that historically have struggled economically. In theory, they have a two-prong benefit; 1) help revitalize dilapidated areas, and 2) stimulate the economy with development and jobs.
If you remember Hurricane Katrina and the devastation it caused in the Gulf States in 2005, the government passed Go Zone legislation that played a major role in helping rebuild areas impacted by the Hurricane. The government hopes for the same results with OZ.
In a nutshell, this tax incentive allows investors to reduce taxable gains and possibly obtain tax-free growth if they re-invest capital gains into real estate within designated Opportunity Zones. This strategy can produce incredible benefits, but the window of opportunity is relatively short (especially if you consider the full development cycle), so you won’t want to sit on the sideline for very long.
The provision provides two stages of tax benefits for those who invest in such a Zone:
- Tax deferral and incremental step-up in basis for funds used to purchase a property in an Opportunity Zone, resulting in partial capital gain exclusion.
- Complete capital gain exemption for the new long-term investment interest in OZ.
WHO: The law mandates that tax incentives are available to Corporations and Partnerships holding at least 90% of their assets in OZ. The partnership or corporation must be organized for the specific purpose of being an investment vehicle in OZ.
Because of this, you will most likely need a new entity for your OZ funds. We at KKOS Lawyers can gladly guide you through the OZ process and at the same time, set you up with the proper entity.
WHAT: The capital gain amount the taxpayer wants to defer must be invested either in an already-existing property, or to build a new property on land purchased in an Opportunity Zone to ultimately be used as a rental or other income producing property. The property must be acquired after 12/31/2017 and be substantially improved while in the hands of the LLC.
WHERE: The Governor of each state has to designate a census tract as an Opportunity Zone. The most up-to-date OZ map can be found here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx. Make sure when you view the map you have the proper layer selected (i.e. “Opportunity Zone Tract”). Generally, opportunity zones are places in your state with lower incomes and higher unemployment rates.
WHEN: The investment must be made within 180 days of realizing the capital gain the taxpayer wishes to defer and the LLC must self-certify as an OZ, LLC within 6 months of being organized.
HOW: In order to qualify, a taxpayer must establish an LLC specifically designated as an OZ LLC and taxed as a corporation or partnership. That Partnership must then invest in an OZ property, within 180 days of when the capital gain was recognized. After the LLC is formed and the property purchased, the taxpayer must be sure to file the appropriate tax forms to self-certify the LLC as an OZ LLC and thereby certify the investment as an OZ investment. Once the LLC is established and the gains are invested in the LLC with at least a portion of those funds invested in the property, the taxpayer may defer recognizing the reinvested capital gains on the current year tax return.
The taxpayer may continue to defer recognition of these gains until December 31, 2026. Unless Congress extends this date, the taxpayer must report the original gains on their 2026 tax return. However, in order to continue to defer these gains, the taxpayer must substantially improve the property within 30 months of the purchase date.
SIDEBAR: The topic of substantial improvement deserves its own article, but here is a summary.
Congress designed this legislation to help areas that have historically struggled to jumpstart their economy. If all a taxpayer had to do to qualify for this program was to buy an existing business, it would not provide much stimulus for the affected area. So, in order to take advantage of these awesome benefits, investors must also improve business property.
Congress has provided two options: 1) the original use of the property must commence with the Opportunity Zone Fund, or 2) the Fund must substantially improve the property.
Before going over these two options, we have to discuss Revenue Ruling 2018-29. In this ruling, the IRS states: “Given the permanence of land, land can never have its original use in a QOZ commencing in a QOF.” They also state that land cannot be substantially improved in a QOZ. Therefore, in order to fulfill either requirement, we have to separate the land from the building and either commence the original use of the property (build a new building) or substantially improve the existing building in order to qualify.
It is clear what is expected in order to qualify under the “original use” option, but what does it mean to “substantially improve” the property? In Rev. Rul. 2018-29, we get our answer.
A building located on land within a QOZ is treated as substantially improved within the meaning of [the statute] if, during any 30 month period beginning after the date of acquisition of the building, additions to the taxpayer’s basis in the building exceed an amount equal to the taxpayer’s adjusted basis of the building at the beginning of such 30-month period.
In layman’s terms, investors have 30 months from the date they purchase the building to double the amount they paid for it. This does not mean the property has to double in value. This would leave too much to chance as investors do not have that much control over the real estate market. However, investors do have control over how much they invest in the property and this will be an easier number for the IRS to police.
Rev. Rul. 2018-29 provides a good example to describe how this requirement works. In this example, QOF A purchases a property for $800k using capital gains. The property was previously used as a factory and QOF A converts it to residential property. Of the total price of the property, 60% ($480k) was attributable to the land, and 40% ($320k) was attributable to the building. QOF A completely remodels the building, spending $400k on the project. Since their additions to basis ($400) exceed the original basis in the building ($320), this investment qualifies as Qualified Opportunity Zone Business Property under IRC 1400Z-2(d)(2)(D).
WHY: Once the investment in the OZ property is made, there are four benefits a taxpayer can take advantage of:
- The gain on the sale is deferred until you divest of the OZ property, or until December 31, 2026, (whichever comes sooner). This is a benefit right out of the gate and, practically speaking, is an interest-free loan from the IRS. You don’t have to pay the tax for up to seven years.
- If you hold the OZ investment for 5 years, you qualify for an increased basis of 10% on the deferred gain. Another way of saying this is you reduce the taxable gain by 10%.
- If you hold the OZ investment for 7 years, you get an additional 5%-increased basis on the deferred gain. This means you only pay tax on 85% of the gain, which you have not paid for 7 years! Therefore, you get to defer the tax bill AND decrease the taxable gain to boot.
- It gets better!! The biggest benefit is that if you hold the OZ investment for at least 10 years, you never pay any capital gains on the OZ investment! That’s right, if you keep it 10 years, you get a stepped-up basis to the market value on the day you sell or dispose of the OZ investment. However, you must remember two important points. a) you still pay taxes on at least 85% of the original gain amount, and b) any operating income or net cash flow from the OZ investment along the way is taxable.
Clay, a real estate investor, owned a single-family rental. He decided he wanted to sell the property and invest in an OZ property or an OZ ‘fund’ (the Fund concept is a topic for another article here).
- Clay purchased the rental for $250,000 in 2010 and was able to sell the property for $500,000 in February 2018. For simplicity’s sake, let’s say his gain was $250,000.
- NOTE: Remember, Clay only has to re-invest the capital gain, and this could be capital gain on any asset. It could be capital gain on selling Amazon stock, gain from the sale of a business, or real estate.
- Within 180 days after the sale, Clay invested the entire $250,000 from the sale into an LLC (taxed as a partnership) with the express purpose of buying, rehabbing and renting multi-family housing units in an Opportunity Zone.
- Clay is able to defer the gain of $250,000 on the sale of his commercial building until 1) he sells the partnership interest, or 2) 12/31/2026.
- Let’s assume Clay never sells the property or his partnership interest, so he recognizes the gain on his 2026 tax return. However, he held the property for at least 7 years, so his basis in the original building has increased by 15% or $37,500. Not only does Clay get to save tax on the increased basis, but he also DIDN’T HAVE TO PAY TAX ON IT FOR 7 YEARS!
- It gets better, though! Because the OZ partnership rehabbing of the rental units went well, his initial investment of $500,000 is now worth over $1 million, and if he keeps the investment for at least ten years, (presumably mid-2030 under this example) he will never pay any capital gains on the partnership investment!
- Did we mention Clay has been receiving income from the rentals all along and deferring that income by taking depreciation on the property, as well?
The beauty of this legislation is two-fold:
- The capital gain can be from the sale of stock, real, or personal property.
- Only the gain amount needs to be re-invested, not the entire sales proceeds (like a 1031 exchange). For example, if you sell a stock for $200,000 and have a capital gain of $50,000, you only need to invest the $50,000 in OZ property in order to take advantage of the tax incentive.
- Do not buy a building inside a QOZ without a plan for how you intend to double your basis in that property. This could derail the whole process and cause you to lose the benefits of the QOZ after just a couple of years.
- Don’t forget to tell your accountant that you invested in a qualified opportunity zone, and make sure they are up to speed on the strategy and process. Once you make the investment in the land or fund, you will make an election on your personal 1040 tax return for the year you would have reported the capital gain. In the example above, Clay would make the election on his 2021 return filed sometime during 2022.
- To take full advantage of all the benefits, you need to make the investment in 2019! You will not get the 15% increase in basis if you invest after 12/31/2019.
- You only have 180 days from the time you incur the capital gain to purchase a property in an OZ or buy into an OZ fund, so act quickly.
If you want to save on taxes when selling an appreciated asset and want to learn more, the IRS has posted some interesting FAQs to help taxpayers take advantage of this amazing opportunity. The good news is, it’s easier than you may think, and it’s certainly much simpler than qualifying for a 1031 exchange.