Created by the Tax Cuts and Jobs Act (TCJA), Opportunity Zones are designed to encourage investment in distressed communities. By reinvesting capital gains into land, buildings, equipment and other assets in Opportunity Zones, investors can defer taxation, enjoy other tax benefits and play an important role in community revitalization.
How Opportunity Zones Work
Qualified Opportunity Funds (QOFs) are the vehicle used to invest in Opportunity Zones. A QOF must hold at least 90 percent of its assets in an Opportunity Zone. To qualify, an area must have a poverty rate of at least 20 percent or a median household income that’s less than 80 percent of surrounding areas. There are currently more than 8,700 Opportunity Zones in the U.S. and five U.S. territories.
To realize the tax benefits of Opportunity Zones, you must reinvest capital gains in a QOF within 180 days of the asset’s sale (or when capital gains would have been taxable). You can make QOF investments directly in tangible property (e.g., land, buildings, and equipment) located in the Opportunity Zone or indirectly through ownership of corporate stock or partnership shares by the QOF in a business that’s located within the Opportunity Zone.
You must elect to defer capital gains by filing IRS Form 8949 with your tax return for the year when the gain occurred.
Paying the Deferred Tax
When you reinvest proceeds from the sale of an asset in a QOF, capital gains will be deferred until the sale of the QOF or December 31, 2026, whichever comes first. If you hold the investment in the QOF until December 31, 2026, you will pay the deferred tax using other liquid funds or by selling a portion of the QOF.
There are two other tax benefits to Opportunity Zones in addition to tax deferral:
- Exclusion of capital gains – If you hold your investment in the QOF for more than five years (your investment must have been made by December 31, 2021), you can exclude 10 percent of the deferred gains from income tax. And if you hold your QOF investment for more than seven years (your investment must have been made by December 31, 2019), you can defer 15 percent of the deferred gains from income tax. In other words, only 90 percent or 85 percent of the capital gain would be taxable.
- Step up in tax basis – If you hold your investment in the QOF for more than 10 years, its tax basis will increase to the fair market value on the day you sell it. In other words, your QOF investment will appreciate tax free, just like a Roth investment.
Note: If you sell your QOF investment in fewer than 10 years, you can roll the proceeds over into another QOF and still retain this tax-free benefit.
A Unique Opportunity
Unlike 1031 exchanges, you don’t have to invest all the proceeds from an asset’s sale into an Opportunity Zone to see tax benefits. A particularly powerful tax advantage is the ability to not only defer capital gains but also eliminate some of the deferred gain and eliminate all capital gains on the Opportunity Zone investment.
Tax advantages like those presented by Opportunity Zones can be enticing, but it’s essential to work with a qualified tax advisor to ensure that you’re satisfying all the requirements and it aligns with your overarching investment goals. Contact Dembo Jones today for a thorough evaluation of how Opportunity Zones — and other investment tax strategies — can benefit your business.