In an effort to encourage private investment in certain economically depressed areas, the 2017 Tax Cuts and Jobs Act created the concept of “opportunity zones.” To date, the IRS has designated approximately 8,500 areas throughout all 50 states as opportunity zones.
The good news? The Act also included a tax incentive for certain investments in these new opportunity zones, presenting yet another “opportunity” for savvy investors.
Reasons to invest in an Opportunity Zone
Investors are sometimes torn between making an investment that produces a high rate of return and socially responsible investments. For some investors, it can be hard to reconcile their personal beliefs with investments that provide favorable returns but could be viewed as damaging the environment or not enhancing the public welfare. Investments in opportunity zones can be a win-win, delivering the desired positive rate of return (coupled with a special tax incentive) while also giving back to the community and promoting economic development and social change.
What are the tax incentives associated with Opportunity Zone investments?
Anyone can invest in an opportunity zone, but it is most advantageous for taxpayers with significant capital gains (i.e., gains from the sale of a capital asset). Investors with large capital gains can elect to reinvest all or a portion of that capital gain into an opportunity zone. To the extent an investor reinvests the capital gain into an opportunity zone, the investor can defer the tax associated with the reinvested gain until the earlier of the date that the investor ceases to maintain its investment in the opportunity zone, or December 31, 2026. Because there are special rules governing the types of capital gain that are eligible for reinvestment into opportunity zones, it is important to consult with a tax advisors prior to investing in an opportunity zone.
There are special rules regarding how much gain the investor must recognize at the time the tax is paid (i.e., as late as December 31, 2026). For most taxpayers, the reported gain is equal to the lesser of (a) the then fair market value (FMV) of the opportunity zone investment or (b) the amount of the deferred gain. If, however, the investor has held the investment for at least five years, the investor may exclude up to 10% of the deferred gain from the amount that would otherwise be recognized. If the investor has held the investment for seven years, the exclusion amount increases to 15%; and if the investor has held the investment for ten years, the investor can elect to exclude all of the post-acquisition gain in the opportunity zone investment - a tax home run! There are no statutory limits on the amount of gain that can be deferred by making investments in opportunity zones.
Similar to the requirements for 1031 exchanges, there are specific time requirements for completing the rollover investment. Although there are some exceptions, the general rule requires the rollover investment to be completed within 180 days from the date of the transaction that triggered the capital gain (i.e., the date of the sale of the capital asset).
How do I invest in an Opportunity Zone?
In order to take advantage of this tax incentive, an investor must invest the eligible gain directly into a qualified opportunity zone business, or into a Qualified Opportunity Fund (QOF).
A savvy investor can create their own QOF for purposes of making the investment or they can invest in an established QOF. There is a multi-billion dollar industry dedicated solely to creating and operating QOFs to facilitate these types of investments. The IRS has issued dozens of pages of regulations concerning the requirements for a QOF. Before making any investment (or prior to starting your own QOF), investors should consult with their tax advisors to ensure that the QOF will comply with all IRS requirements.
Richard P. Breed, IV is an attorney at Tarlow Breed Hart & Rodgers, P.C. in Boston, MA. Attorney Breed focuses on legal issues surrounding taxation, corporate law, and estate planning & administration. He can be contacted at (617) 218-2028, or via email at firstname.lastname@example.org