Opportunity Zone (OZ) investments allow you to re-invest any capital gain (from stock, real estate, etc.) into an OZ qualifying investment and obtain tax deferral of your gain, taxable gain reduction, and tax-free growth of your qualifying OZ investment. It’s a rare opportunity for massive tax benefits and it’s just getting started. This article is the first of a series that will break down this significant tax planning opportunity.
OZs are another key to help states jumpstart communities that have struggled since the economic downturn, but the window for realizing the great benefits of OZ investment is relatively short (especially if you consider the full development cycle), so you won’t want to sit on the sideline very long.
The provision provides two stages of tax benefit for those who invest in OZ (both are explained below):
- Tax deferral and incremental step up in basis for funds used in OZ as longer term investments, resulting in partial capital gain exclusion.
- Complete capital gain exemption for the new long term investment interest in OZ.
WHO: The law mandates the 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, and must be established after December 31, 2017.
- You will most likely need a new entity for your OZ funds because of this, and we will gladly help with you get it set up properly.
WHERE: The where is the actual OZ is. The Governor of each state has to designate a census tract as OZ. The most update 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, they are places in your state with lower incomes compared to median and higher unemployment rates. You will notice from the maps that some Governors (Brian Sandoval, Gary Herbert) have yet to gain approval for their census tracts. Have no fear, they will be coming! There are, however, numerous states that have already designated their tracts (e.g. AZ and CA).
WHAT: The OZ fund you choose to invest with or establish must be invested in at least one of the following: any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.
- For the stock provision, it is stock in a business that was acquired after 12/31/2017 in exchange for cash, and the corporation is an OZ business or has been organized for the purpose of being an OZ business.
- The partnership rules are essentially the same as the stock, but with partnership designation (i.e. same dates for interest purchase, must be OZ or organized for OZ business).
- Business Property tangible business property used in a trade or business in OZ. The property must be acquired after 12/31/2017, and the property is substantially improved, which means the adjusted basis in the property must be increased while in the hands of the fund.
WHY and HOW are related so we can deal with them together. For starters, you must sell or dispose of property for cash with capital gains in the 180 days prior to making an OZ investment. The gain on the sale is deferred at least until you divest of OZ or until December 31, 2026, whichever comes sooner. If you hold the OZ investment for 5 years, you qualify for an increased basis of 10% on the deferred gain. If you hold the OZ investment for 7 years you get an additional 5% increased basis on the deferred gain, which means you only pay tax on 85% of the gain, which you have not paid for 7 years! That means you get to decrease the taxable gain amount and you get defer when you pay.
The best part though, is that if you hold the OZ investment for 10 years, you never pay any capital gains on the OZ investment! That’s right, you get a stepped up basis to the market value on the day you sell or dispose of the OZ investment if you keep it for 10 years! Talk about eating your cake and having it too! The operating income or net cash-flow from the OZ investment is taxable but the gain on the sale of assets or the interest falls under these special rules.
Clay, a real estate investor, owned a single family rental. He decided he would like to sell his rental and invest into an OZ fund.
- Clay purchased the rental for $250,000 in 2010, and was able to sell the rental for $500,000 in February 2018. For simplicity’s sake, let’s say his gain was $250,000.
- NOTE: You only have 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.
- In the 180 days after the sale, Clay invested the entire $250,000 from the sale into a partnership with the express purpose of buying, rehabbing and renting multi-family housing units in an OZ.
- Clay is able to defer the gain of $250,000 on the sale his commercial building until 1) he sells the partnership interest, or 2) 12/31/2026.
- He never divests of 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 is increased by 15% or $37,500. Not only does Clay get to save tax on the increased basis, HE DIDN’T HAVE TO PAY TAX ON IT FOR 8 YEARS!
- It gets better though, because the OZ partnership rehabbing of rental units went well. His initial investment of $500,000 is now worth over $1 million, and if he keeps the investment for 2 more years he never pays any capital gains on the partnership investment!
- Did we mention Clay has been receiving income from the rentals all along as well?
Give us a call and set up a consultation with one of our expert Tax Attorneys to discuss how you can benefit from an OZ investment!