Opening Take on the New Opportunity Zone Federal Tax Law

Do you have potential capital gains from capital asset holdings that you want to reinvest in real estate or another business? I just closed the sale of a rental property which had a substantial built-in capital gain. If your potential gain is from the sale of real estate, maybe you are looking at a 1031 like kind exchange to defer capital gains tax. Now we have an alternative tax benefit strategy that applies to any capital asset (including stock sales) and has some advantages (and disadvantages) over a 1031 exchange.

Please note: my discussion of tax law below should not be interpreted as legal advice. As always, you should consult your legal and/or tax advisor for advice on how this law may apply to your personal circumstances.

The 2017 federal Tax Cuts and Jobs Act (TCJA), which took effect at the beginning of 2018, provides a tax benefit on capital gains that are invested in “Qualified Opportunity Funds” which invest in "Opportunity Zones" around the country. I jumped into research and due diligence mode at the beginning of November 2018.

Why? Because I just closed the sale of a foreign rental property with a large built-in gain, and under the new law, I have 180 days from the close of the sale to reinvest in a Qualified Opportunity Fund (QOF) in order to derive the benefits it provides.

In a nutshell, the new tax law allows you to defer gains from the sale of capital assets by investing those gains into a QOF which invests in “qualified opportunity zone property” (including real estate and other business assets). You have 180 days from the date of sale to do the investment. Capital assets include stock or real estate investments.

Unlike a 1031 exchange, the gains cannot be deferred indefinitely. They must be recognized on December 31, 2026 (unless you sold your QOF investment earlier, which triggers gain recognition at the earlier time). However, if you hold the QOF investment for at least 5 years, you get a 10% increase in your basis (or reduction in your taxable gain) in the original investment. If you hold the investment for at least 7 years, you get an additional 5% increase in your basis (a 15% step-up in total).

On the plus side, you can invest gains from any capital asset into a QOF, not just exchange real estate for real estate. Another difference with the 1031 exchange rules is that you only have to reinvest the gain from your asset sale to get the maximum tax benefit, i.e. you can pocket your original investment in the asset. Under the 1031 exchange rules, you would only receive a pro rata tax deferral benefit to the extent that you reinvested the sales proceeds of the asset sale (including your original investment).

There’s more. If you hold the QOF investment for at least 10 years, you can avoid federal capital gains tax on the appreciation of your QOF investment during the holding period. At that point, you can cash out of the investment and walk away with no further federal capital gains tax due. Nice.

Where are these Opportunity Zones? They are located in designated areas across all 50 states plus Puerto Rico. The zones were selected by the state governors in the first half of 2018 and must adhere to specific criteria. Generally they are low-income areas where state and local governments would like to boost investment and promote economic development.

How do you invest in a QOF? From what I have learned so far, you can either invest in an existing fund with professional management or set one up yourself with an LLC/partnership or a corporation. The IRS has published an FAQ and some proposed regulations which provide initial guidance on how to get started. It has promised to issue more details over the next few months.

In this blog I will share my own personal journey in figuring out where to invest to take advantage of this new tax benefit and how to maximize my investment (both with respect to the tax benefit as well as general investment criteria)

Some real estate developers and rehabbers may already be in some of these areas because of the investment potential alone. From a cursory review of the zones in my state, I see some areas that are already in transition and undergoing gentrification. My initial thinking is that QOFs will focus on the areas where other investments are being made. They will try and ride the wave of overall economic growth in a particular area.

From my initial research, large syndicators and developers are already starting QOF projects, but I think there is definitely room for the individual or small-scale investor to play in this arena.