2017 Tax Act and Qualified Opportunity Zones: Is It Really an Opportunity?
July 5, 2019
Written by Russell Bucklew, Partner, CFP®, JD and Christopher Bergthold, Senior Client Associate, CFP®
The Tax Cuts and Jobs Act of 2017 (TCJA) included a tax break for investors related to realized capital gains. Through this program, an investor may receive tax benefits, including potential deferral and elimination of tax, by investing those gains in a Qualified Opportunity Zone Fund (QOZF).
Qualified Opportunity Zone Funds are investment vehicles targeting properties, businesses, and other assets within outlined opportunity zones in the US. These zones were created alongside the TCJA and are designed to incentivize investment in distressed areas. There are around 8,700 opportunity zones demarcated across the country, and investors can receive significant deferral and in some cases a reduction in capital gains taxes by investing in opportunity zones.
How do opportunity zone tax benefits work?
General Tax Benefits
The first tax benefit is the temporary deferral of federal income tax on realized capital gain until the earlier of the taxpayer’s disposition of the QOZF interest or Dec. 31, 2026. To receive this benefit, the taxpayer must invest the capital gain into a QOZF within 360 days of the capital gain triggering event. At the end of the deferral period, the taxpayer must include in gross income an amount equal to the excess of (a) the amount of deferred capital gain (or the fair market value of the QOZF investment if lower) over (b) the taxpayer’s basis in the QOZF, which is initially treated as zero.
The second tax benefit is up to 15 percent of the unrealized (deferred) gain invested in a QOZF is eliminated if the investment is held for at least seven years prior to Dec. 31, 2026. This happens through a basis increase equal to 10 percent of the deferred gain, if the investment is held for five years, and a further 5% basis increase in year seven. In order to receive the full 15% benefit, the QOZF investment must occur no later than Dec. 31, 2019.
The third benefit is that no federal income tax will be paid on QOZF appreciation if the investment is held for at least ten years. The benefit comes from a taxpayer election to increase its tax basis for the fund to fair market value at the time of the sale or exchange of the investment. This election can only be made for sales transactions that occur no later than Dec. 31, 2047.
- Investors may reinvest capital gains from existing investments and defer, and potentially reduce, capital gains taxes.
- If held, the original investment’s tax basis increases by 10% after five years and by 15% after seven years.
- After ten years, investors may permanently defer gain from contributed assets with unrealized appreciation and eliminate capital gains from the appreciation of opportunity zone investments.
A business owner contributes $11 million asset with $1 million of basis and a long-term cap of $10 million. During the ten-year period, the $11 million asset appreciates $7 million to $18 million.
Year One: Client owes 23.8% or $2,380,000 in long term capital gain tax. ($10 million x 23.8% = $2,380,000)
Year Five: Client received 10% basis increase to $1,100,000; gain is reduced to $9,900,000, and tax is reduced to $2,356,200.
Year Seven: Client received an additional 5% basis increase to $1,150,000; capital gain is reduced to $9,850,000, and tax is reduced to $2,344,300. Total tax savings on basis increase is $35,700.
Year Ten: Client pays no tax on the appreciation of QOZF investment with an unrealized gain of $7 million, referred to as “interim gain.” The capital gains tax avoided on the appreciation in the QOZF investment is $1,666,000. Adding the basis adjustment tax savings of $35,700 to capital gain tax avoidance of $1,666,000, bringing the total tax savings to a total savings of $1,701,700.
Disclaimer: This example is for illustration purposes, using the highest capital gains tax rate (20%) and a 3.8% net investment income tax. There may be additional considerations including, but not limited to, state income tax, holding period, basis calculation, alternative minimum tax, and other factors. Please consult with your tax advisor for advice on your specific scenario.
The Hot Financial Topic
There’s enthusiasm for the new tax breaks provided by opportunity zones. However, there are many questions about how the law is applied, and the uncertainty is causing investors to delay putting funds to work. Brett Theodos, a senior researcher at the Urban Institute, said the administration has signaled it is interested in gathering more data. However, for now, he said there are “more questions asked than answers’’. Senators Cory Booker, a New Jersey Democrat who’s seeking his party’s presidential nomination, and Tim Scott, a South Carolina Republican, plan to introduce legislation requiring the IRS to collect data from tax-break recipients to show how their investments are altering economic conditions in their opportunity zones. In other words, is this legislation a tax ‘give-away’ for the rich only, or is it accomplishing its intended purpose of rehabilitating and changing the landscape of economically hard-hit areas?
One of the first funds that hit the ground running is Virtua Partners, a Phoenix-based private equity firm. In July 2018, they launched their first QOZF called Virtua, a $200 million fund that includes three Phoenix-area projects: a 130-room Marriott hotel with furnishings by West Elm, 81 single-family townhomes with a swimming pool and clubhouse, and a 90-unit apartment complex near Arizona State University’s campus in Tempe. According to Virtua representative Derek Uldricks, all three projects would have been completed even without the tax break, but the tax breaks accelerated fundraising by attracting additional investor interest.
Another Phoenix-based real estate firm – Caliber – launched a QOZF to gather $500 million in investor capital targeting $1 billion of hospitality, commercial, and residential real estate investments in the Southwest growth markets of Arizona, Texas, Colorado, Nevada, and Utah. According to Brion Crum, Director of Strategic Relationships, Caliber was able to reposition and take advantage of existing projects in opportunity zones. Interest in opportunity zone investing resulted in additional investor capital, allowing Caliber to expand the purpose and scope of existing projects. Examples include a new hotel for Tucson’s convention center, a revitalization of historic downtown Mesa in a mixed-use project, and energy-efficient townhomes in Tempe.
Some investors are buying in opportunity zones to take advantage of the tax benefits in areas that meet the letter of the law, but not the spirit. In other words, some properties fall within the technical definition and fit in the geographic location but may not be distressed or fit the spirit of what the legislation envisioned. Caliber is seeking to invest in impoverished areas and those intended to benefit from the policy and purpose behind the legislation. Essentially, they are investing in the path of progress, but in distressed areas translating into value pricing and more potential for upside appreciation. One example Brian gave is a large tract of undeveloped land south of Coors Field in Denver, Colorado; while it lies within the geographic parameters and the path of progress with potential for upside appreciation, it is genuinely a distressed area and one that will benefit by redevelopment. This appears to be a very sound strategy.
According to Brian, most of the investment in QOZF stems from business owners transitioning into retirement and sales of professional businesses like doctors exiting their practices. Investors selling concentrated positions of stock may also qualify for the tax break. For example, investors who own low basis, appreciated positions in growth stocks like Apple or Google might defer and reduce significant capital gains, invest in QOZF, and reduce or eliminate the gain on the QOZF investment. Real estate investors may also use QOZF to identify qualified property under the like-kind exchange rules in IRC 1031, allowing an investor to “defer” paying capital gains taxes on the sale of an investment property.
Investing in opportunity zones is brand new, and the final verdict is yet to be determined. Many of the technical rules are still being ironed out, and there are potential traps and unintended consequences. The legislation intends to drive rehabilitation and renovation in poor neighborhoods by providing economic stimulus and social benefits and attracting attention to these areas. Examples include retail, restaurants, apartment buildings, and new manufacturing facilities, to name a few from a long list of possibilities. However, the adage “don’t let the tax tail wag the dog” applies here. In other words, don’t be so focused on tax issues that you lose sight of basic investment principles. See Maneesh Shanbhag article: What is the Opportunity Zone Tax Incentive Really Worth?.
High net worth investors and people transitioning appreciated assets with built-in capital gain are excited about the tax planning opportunities with Qualified Opportunity Zone Funds. This subject is a hot topic at country clubs, cocktail parties with the elite, and professionals including money managers, attorneys, and accountants. No question there are planning opportunities and exciting tax minimization strategies available to taxpayers staring at significant taxable gains. However, we should not allow the “flavor of the day” or the newest idea to steer us away from our discipline and process around investment choices.
To keep us focused and disciplined, here are four rules to help guide our decision making:
- The investment has merit on its own, regardless of the opportunity zone tax benefit. If you get tax incentives but don’t make any money, it doesn’t make sense.
- The solution will fully qualify for the intended benefits. There are some funds that will mix opportunity zone qualifying deals with non-qualifying deals. Mingling the two may give your accountant stomach acid. Consider single strategy solutions and don’t mix the two.
- The operator should have a long track record of success. We don’t want to invest with someone who is starting their first fund to capture opportunity zone money and earn a fee. Invest with experienced real estate developers and managers who can enhance returns with the opportunity zone tax benefit.
- Fees need to be reasonable. Access to opportunity zones shouldn’t increase costs.