Real estate investors across the country are asking how to tap tax benefits for investing in projects in low-income areas, known as “Opportunity Zones” under an obscure provision of the 2017 Tax Act. They may not have to wait much longer – the federal government just released guidance for comment.
Nuts and Bolts
A little background is needed since the program is so new. As part of last year’s Tax Cut and Jobs Act, authors of the bill included tax benefits to defer or reduce capital gains taxes. According to the IRS, an Opportunity Zone is an economically distressed area of a community where new investments, under certain conditions, may be eligible for preferential tax treatment.
After the bill became law, the Governor’s office, designated 128 low-income census tracts as Opportunity Zones eligible for investment under the new law and the U.S. Secretary of Treasury approved the designation. The principle benefit of investing in an economic development project within an Opportunity Zone is the deferral of taxes on prior capital gains. In addition, if an the investor holds the investment in an Opportunity Fund for at least 10 years, the investor would be eligible for an increase in basis equal to the fair market value of the investment on the date that the investment is sold or exchanged.
A qualified Opportunity Fund is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in an Opportunity Zone and that utilizes the investor’s gains from a prior investment for funding an Opportunity Fund. Investors don’t need to live in the Opportunity Zone to take advantage of the tax benefits. Investors simply need to invest in a qualified Opportunity Fund.
Tax Benefits
To qualify for the tax benefit, the investor self certifies. In other words, there is no approval by the IRS to certify eligibility. The taxpayer completes a form issued by the IRS and attaches that form to their taxpayers Federal Income Tax Return for the taxable year. As an example, if an investor sells stock in 2018 and invests in a qualified opportunity fund within 180 days of that sale, the investor can defer the gain on the sale. At the time of filing a federal tax return, the taxpayer may elect to defer all or some of the gain.
There are a few important things to keep in mind when deciding whether to use this economic development tool to spur redevelopment of the property. This is an investor incentive, not one that is awarded to individual companies. All incentives relate to capital gains, present and future, not operating revenue or cost. There are no upfront appropriations by local, state or federal government. Because the program is market based, investors will determine whether or not they see tax benefits through investment in economic development projects.
In short, the program offers investors three specific incentives for investing unrealized capital gains in eligible projects.
- Deferral – an investor may defer capital gains taxes until 2026 by investing and keeping unrealized gains in an Opportunity Fund.
- Reduction – the original amount of capital gains on which an investor has to pay deferred taxes is reduced by 10 percent if the Opportunity Fund investment is held for five years and another 5 percent if held for seven years, for a total reduction of 15 percent.
- Exemption – any capital gains made on investments made through the Opportunity Fund accrue tax free as long as the investor holds them for at least ten years.
Proposed Guidance Released
The Treasury Department and the IRS recently released guidance for the Opportunity Zone tax incentive and will take public comments until a hearing for January 10, 2019.
After that, the guidance will be finalized to give better direction on how investors can use this new economic development tool. In the meantime, investment firms have already begun creating Opportunity Funds by aggregating investments based on the assumption that there will be a limited window in which to make qualified investments.