Within the hundreds of pages of the latest tax reform legislation, one of the least publicized—yet most powerful—tax benefits that came out was the Opportunity Zones program.
This government program offers three powerful tax advantages to real estate investors:
- The ability to defer capital gains taxes on the sale of real estate
- The ability to permanently eliminate part of the capital gains taxes
- The potential ability to receive permanent tax-free gain on 10-years of forced appreciation
The Purpose of Opportunity Zones
The Opportunity Zones (also called O-Zone) program was enacted to help improve certain distressed communities. The government’s goal was to provide tax incentives to bring in private investments in housing and other sections to revitalize these areas. Areas designated as Opportunity Zones can be found throughout all 50 states.
What Are the Tax Benefits of Investing in Opportunity Zones?
1) The ability to defer capital gains taxes on the sale of real estate.
Let’s look at an example. Jim, a resident of Florida, bought a rental for $100K at the end of 2016. In 2018, he sold it for $250K. For simplicity purposes, let’s assume $0 depreciation was taken.
Instead of paying capital gains taxes on his $150K gain, he invests the $150K into an Opportunity Zone Fund within 180 days of the sale. He calls it Ozone Fund, LLC.
This strategy will help him to defer capital gains taxes of $22,500 in 2018 (assuming a 15 percent capital gains rate).
2) The ability to permanently eliminate part of the capital gains taxes.
This means that not only will Jim defer the tax by not paying it in 2018, but he will also eliminate a portion of the taxes so that he never has to pay it in the future either.
Ozone Fund, LLC uses Jim’s $150K investment to purchase a duplex in Florida. Jim puts in an additional $100K to improve the building and turn it into a great cash-flowing property.
After holding the duplex via Ozone Fund, LLC for five years, Jim’s original capital gains of $150K will reduce by 10 percent (down to $135K), and he will have permanently eliminated $2,250 in taxes.
($150,000-$135,000) X 15% capital gains rate
In the future, Jim will only need to pay capital gains tax on $135K instead of the original $150K gain.
If Jim continues to hold the investment for at least another two years (a total of seven or more years), then his original capital gains of $150K will reduce by 15 percent—as opposed to 10 percent after five years (down to $127,500). Jim will have permanently avoided paying $3,375 in taxes.
($150,000-$127,500) X 15% capital gains rate
In the future, Jim would only need to pay capital gains tax on $127,500 instead of the original $150K.
3) The ability to receive permanent tax-free gain on appreciation.
Jim decides to continue holding onto the property in Ozone Fund, LLC. After a total of 10 years of ownership, Jim will also be able to receive permanent tax-free appreciation of the property.
Let’s assume that at the end of 10 years, the duplex is now worth $550K. Here is what the benefit looks like assuming $0 depreciation:
$550,000 Fair Market Value at the End of Year 10
$127,500 Tax Basis After Gain Recognized 12/31/26
$100,000 Improvements Made
$227,500 Total Cost Basis
$322,500 Tax-Free Gain (FMV – Cost Basis)
15% Capital Gains Tax Rate
$48,375 Total Permanent Tax Savings
In Jim’s example, he will be able to save up to $48,375 of taxes permanently! In fact, if he chose to, he may be able to continue holding this property until 2047 to continue the tax-free growth.
How to Invest in Qualified Opportunity Zones
Now that we know how powerful this new tax benefit can be, let’s go over some of the rules on how to qualify.
Qualifying Opportunity Zone Properties
Unfortunately, simply buying a property that is within one of the IRS-designated Opportunity Zones will not automatically qualify you for these wonderful tax benefits. Since the goal of the program is to improve distressed communities, additional conditions must be met.
These requirements include:
- The property must be purchased after 2017.
- Substantial improvements must be made to the property within a 30-month period. In real estate terms, this means that the owner must spend an amount at least equal to the purchase price of the building. For example, Jim purchased the Opportunity Zone duplex for $150K. For this property, $50K of the purchase price was allocated to land and $100K was allocated to the building. Jim will need to put in at least $100K of improvements within a 30-month period in order to meet the substantial improvement requirement.
- The property must be held by a Qualified Opportunity Fund.
Forming a Qualified Opportunity Fund
Investors must first reinvest capital gains into a Qualified Opportunity Fund (QOF). The fund will serve as the investment vehicle to purchase property within a Qualified Opportunity Zone.
A QOF must meet all of these requirements:
- The fund must be a U.S. legal entity that files its own tax return (i.e., corporation, partnership, or multi-member LLC). This means that Jim would not have been able to simply purchase the duplex in his personal name or in a single member LLC of which he was the sole owner.
- The legal documents of the entity must indicate that it is organized for the purpose of investing in Qualified Opportunity Zone property.
- The fund must hold at least 90 percent of its assets in Qualified Opportunity Zone property. As such, we recommend using a new entity to act as a QOF and not using an existing entity that holds other non-Opportunity Zone properties.
- The self-certification must be made by the fund each year by filing Form 8996 with its federal income tax return by the return’s due date. This means that you will not have a qualified fund if the tax return is filed late. The self-certification should also indicate the first month in the initial tax year that the QOF begins.
Keep in mind that Opportunity Zone tax benefits are not limited only to the sale of rental real estate. The program can help to defer taxes on all sorts of capital gains income. Some examples can include gains from the sale of stocks, partnership interests, business interests, and even primary homes.
Reinvesting Capital Gains
Here’s another important detail to note: you only need to reinvest the capital gains portion of a property’s sale—unlike a 1031 exchange, where you must reinvest the entire sales proceeds.
So, in Jim’s example, he could have chosen to reinvest any portion of his $150K. If he were to do a 1031 exchange, Jim would have been required to reinvest the entire amount of the property sale, which was $250K.
Similar to a 1031 exchange, however, the IRS does require the money to be reinvested within 180 days of the sale. (There are unique instances when the taxpayer may have longer than 180 days though.)
Other benefits of the Opportunity Zone program that make it better than a 1031 exchange include:
- the ability to choose how much to reinvest into the new deal
- the ability to receive the tax benefit without an exchange intermediary
- the ability to avoid the 45-day identification rule
In fact, an Opportunity Zone can be a great last-minute strategy for investors who either failed a 1031 exchange or have taxable money from a 1031 exchange transaction that they would like to defer.
Completing a Tax Election
If you have met all of the requirements above, you should be in the clear to get all these wonderful tax savings, right?
Not just yet. Yet another requirement is that an election for tax deferral must also be made by the taxpayer and attached to their tax return for the year of the gain.
Critiques of the Opportunity Zone Program
As with everything in taxes, there is often some bad that comes with the good. This new tax break is no exception.
A big pitfall of the Opportunity Zones program is the requirement to pay taxes by the earlier of the property sale date or December 31, 2026. A 1031 exchange, on the other hand, can allow you to potentially defer taxes indefinitely.
So, to reiterate, a taxpayer can only defer taxes until 2026 for an Opportunity Zone transaction. This is true even if the taxpayer decides to continue holding onto the property past the 2026 mark.
In Jim’s example, for instance, if he holds onto his duplex, he would need to pay taxes on his $127,500 of deferred gain on his 2026 tax return ($150,000 minus his 15 percent adjustment for holding it more than seven years).
Summary of the O-Zone Program
As you can see, the Opportunity Zones program provides for some extremely powerful tax-saving opportunities. However, there are many hurdles to overcome and requirements that must be met in order to qualify for these tax breaks.
Unless you are a savvy investor who has a good amount of experience dealing with large improvement projects, you may be better off passively investing in someone else’s Qualified Opportunity Fund. In fact, many syndications currently exist where you can be a passive private equity investor in large funds.
The upside is that you’d receive these tax advantages without having to do all the work. Keep in mind, though, that just about anyone can create a fund. Therefore, it’s important to carefully analyze these types of passive investments. Ensure that the fund and its operators are reputable and that it does indeed meet all the IRS requirements.
If you are considering a sale transaction that may result in a large tax gain, speak with your tax advisor to determine whether the Opportunity Zones program could be a good opportunity for you.
Do you plan to invest in Opportunity Zones? Do you already have experience doing so?