A shorter version of this article, “U.S. Opportunity Zones: Incredible Tax Savings For Entrepreneurs?”, first published on Forbes.com.
You may have heard about Opportunity Zones and their tax savings potential after the 2017 tax law went into effect. Through investment in opportunity zones, you can defer and reduce capital gain taxes.
At the same time, this supports the development of distressed communities. Sound like a win-win, not just for US-based investors. Even foreign investors and expats benefit from opportunity zone tax savings.
Minimize capital gain tax with investments in opportunity zones
Opportunity zones are designated areas in distressed communities that offer preferential tax treatment for new investments. Specifically, you can defer taxes on any capital gains placed in a Qualified Opportunity Fund (QOF) through the end of 2026 or when the investment is sold, whichever comes first.
Additionally, the capital gain tax deferral is not the only tax benefit of opportunity zone investments. There are actually three tax benefits of investing in opportunity zones:
- Deferred capital gains tax for original capital gains.
- A discount of up to 15% on the taxable amount of original capital gains after seven years.
- No capital gains tax on opportunity zone investment if held for 10 years or more.
As you can see, the opportunity zone program offers tax breaks for both the original capital gains that you invest and for the gains from that investment.
Let’s look at the savings potential in an example. Assuming you have a recognized $100,000 profit on the sale of stock in a public company. By investing the gain in a qualified opportunity fund, you can postpone capital gains taxes until 2026. If you hold your fund shares for five years, your $100,000 deferred gain is reduced by 10 percent to $90,000. After seven years, it is reduced by another 5 percent to $85,000.
When selling after 10 years, you can even exclude any appreciation in the value of the QOF shares. Let’s say the initial investment of $100,000 increased in value to $180,000. The $80,000 gain is entirely tax-free. (Your original capital gain would be $85,000 since the deferred gain was reduced by 15% for tax purposes.)
This is an incredible tax saving. In addition, you have a bigger amount available for investment, since you don’t have to pay capital gain tax right away.
Investing through Qualified Opportunity Funds (QOF)
However, you can’t just buy a property in a distressed community and call it a qualified investment. Instead, individuals must invest through Qualified Opportunity Funds (QOF). A QOF should be set up as a corporation or partnership. On the plus side, a new QOF does not need official approval from the IRS.
You can self-certify your fund as a Qualified Opportunity Fund by completing Form 8996 and attaching it to your federal tax return for the taxable year.
At least 90% of the fund’s assets must be in qualified Opportunity Zone property. Tangible property used in a business located in a designated Opportunity Zone and purchased after December 31, 2017, qualifies. Not only real estate but investing in any businesses located in the opportunity zones qualifies for this tax break.
Should the property for some reason cease to qualify, it will still be treated as qualified opportunity zone business property for five years, or until the business sells it before those 5 years.
Eligible investments for opportunity zone tax benefits
Only recognized capital gains for federal income tax purposes can benefit from the opportunity zones tax breaks. Those gains cannot stem from a sale to a related person.
This means that any foreign investor with capital gains subject to US federal income tax can utilize the program to save taxes.
Short-term vs long-term capital gains
The tax benefits are not limited to long-term capital gains. If you invest short-term capital gains into an opportunity fund, the tax will be deferred but they will not become long-term gains after being deferred or reduced.
You can also invest money other than capital gains in opportunity zones. Those investments however will not benefit from the incredible tax incentives.
There is no lower or upper limit to the investment; you can invest as much or as little as you want.
Timing is important to realize opportunity zone tax savings
This is not a quick tax-avoidance scheme. To realize the most tax savings requires a long-term commitment from the investor.
Be aware that the opportunity zone program is set to end on December 31, 2026. You cannot defer gains past that date. That means to get the full 15% discount available after 7 years you must invest by the end of this year. Investors receive a 10% discount on their capital gains tax after holding the investment for 5 years.
You only have 180 days after selling assets to invest the realized capital gain in an opportunity zone fund.
Remember that you must make an election to defer the gain on the tax return on which the gain would be reported if you do not defer it.
Should you invest in opportunity zones?
Investors should evaluate opportunity funds the same way they would evaluate any investment option. This is still very new and more specific guidance for funds is pending.
Furthermore, keep in mind the timeframe required for the big tax savings. While a capital gain tax deferral on a shorter-term investment may still be worthwhile, the tax reduction for the original capital gain tax and the tax-free investment gain is only available after many years.
Still, the opportunity zone program gives investors the option to sell appreciated assets and invest the capital gains while deferring capital gain taxes. We regularly advice individuals if an opportunity zone investment is right for them and how to execute it properly.
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