To taxpayers facing large capital gains, very few strategies exist to defer or eliminate the tax altogether. That all changed with tax reform. The Tax Cuts and Jobs Act passed at the end of December 2017 created major changes in the tax structure, and not the least of these may be found in IRC Sections 1400Z-1 and 1400Z-2, the code sections that govern Opportunity Zones.
These changes enable investors to take advantage of heretofore unavailable tax breaks that can save huge amounts of money through preferred treatment of capital gains. Why give people the chance to skip capital gains tax you might ask? The purpose of Opportunity Zones is to stimulate economic development and job creation in distressed communities by giving significant tax breaks to those who invest in them. Locations may become Opportunity Zones through nomination by a state followed by certification by the Treasury Department.
The benefits of investing in Opportunity Zones feature 3 powerful advantages. First, the opportunity to defer tax on recent capital gains for up to 8 years. Second, to permanently eliminate up to 15% of the total capital gain that was deferred. Finally, the
ability to permanently eliminate any capital gain created through the new investment.
Investment in Qualified Opportunity Funds
The process begins with capital gain deferral. In order to qualify, individuals, business entities, estates and trusts may invest through Qualified Opportunity Funds (QOFs), which are partnerships and corporations for investing in eligible properties located in Qualified Opportunity Zones. Investors must invest the desired amount of capital gain to be deferred into a QOF within 180 days of the realization of the gain to take advantage of tax benefits. Qualified Opportunity Funds must invest a minimum of 90 percent of their assets into revenue generating activities located within an Opportunity Zones to qualify.
Benefits to Investing in Opportunity Zones
Investors may defer tax on almost any prior gains invested in a Qualified Opportunity Fund (QOF) up to Dec. 31, 2026, and capital gains will not be taxed until then or when the investment is sold, whichever comes first. This deferment can result in a return on investment that is twice as high as that of a traditional stock portfolio. The IRS issued proposed regulations on October 19, 2018; they issued further clarifications at the end of the 2018 and final rules by the spring of 2019.
The amount of the capital gains exclusion depends on how long the investment is held:
If the investor holds the investment for over five years, there is a 10% permanent exclusion on the deferred gain.
If the investor holds the investment for over seven years, there is a 15% permanent exclusion on the deferred gain.
Should the investor hold the investment for 10 years or more, the IRS will permit them to increase the basis of the QOF investment to its fair market value on the date that they sell or exchange the QOF investment.
This effectively means taxpayers will recognize no taxable gain on QOF investments if held for 10 years or more!