Written into law by the Tax Cuts and Jobs Act of 2017 (TCJA), the Federal Opportunity Zones initiative is a tool aimed at promoting private investment in underserved communities across the country. While many Americans only know it as government-speak, every day more investors are understanding what it really is, a way to defer tax on capital gains.
Scattered across the country, opportunity zones are in areas deemed by the census as distressed or low-income, where investment will prove to be a valuable asset to the community. Investors can defer taxable gains on sales of investments by reinvesting the proceeds in a Qualified Opportunity Fund (QOF). A QOF is an investment tool set up to execute the tax deferral where the QOF holds at least 90% of its assets in a Federal Opportunity Zone.
Essentially, the program helps communities by allowing investors to defer taxes. Ultimately, it is a win-win.
Federal Tax Incentives
Being a federal program, the most significant benefits come at the federal level. When property or assets are sold at a gain—whether an office building or significant investment holdings in stock—taxpayers are liable for the tax on the gain. Federal Opportunity Zones offer investors the opportunity to get around that by using what are known as DRE benefits —deferral, reduction, and exclusion.
To take advantage of this benefit, within 180 days of triggering the gain, the investor must reinvest those funds into a QOF to take advantage of the deferral. The immediate benefit to making the investment is taxable gains being deferred from the fiscal year in which they were realized. Over time the QOF investment not only appreciates, but also sheds its taxable burden. After five years, 10% of the initial investment is excluded from taxable gains, and after seven years 15% is excluded. If the investment in the fund is held for ten years, the appreciation on the QOF investment is exempt from taxes.
Local Tax Incentives
While helping struggling communities can be enough of an incentive for some investors, for others, the benefits that cascade from the federal level into states and municipalities is another selling point. After the TCJA was signed into law, the Congress requested that states adopt the same Opportunity Zone Provisions to their tax code as the federal government. As with many federal-state relationships, the laws vary depending on what part of the county you’re in.
In the 34 states that adopted the federal legislation, individuals can take advantage of the same DRE benefits at the state level as the federal government. By investing in QOFs, some individuals are eligible for eliminating most of their tax liability for capital gains on the appreciation of the investment.
But as anyone who has scouted locations for businesses knows, Opportunity Zones are only a small part of the tax incentives that states use to woo companies into laying a foundation within their borders. Property tax abatements, income tax credits, and sustainability incentives are some of the other tools that states have in their kits, and companies seeking to take full advantage should be intentional about doing so.
Using a simple example to illustrate the benefits, imagine having bought 1,000 shares of Amazon in 2006, each at about $30 per share, for a total investment of $30,000. Fourteen years later, imagine having sold the stock at its recent high of approximately $3,420 per share, for a gross income of approximately $3.4 million. Depending on their marital status, annual income, and state of residency, the investor is likely to pay roughly one-third —$1 million—in taxes on those gains.
Enter an opportunity. If the investor had reinvested the gains into a Qualified Opportunity Fund, which holds 90% of its assets in a Federal Opportunity Zone and defers the tax, after seven years the income would hit the investor’s balance sheets at 85% of the total gains, for a total burden of approximately $850,000, which is $150,000 less than if it were taxed prior.
In 2030, after 10 years of holding the gains in the QOF while continuing to grow the money as the fund adds value, the investor withdraws the initial capital that has already been taxed in addition to the appreciation on that initial investment without tax liability.
Federal Opportunity Zones are aptly named—they are truly an opportunity. If done properly, businesses of any size and investors can benefit their long-term planning by investing in a QOF and save millions of dollars of tax liability while continuing nontaxable growth.
Investors who have not yet taken advantage of the program should move quickly for a few reasons.
- The tax benefits of a QOZ include a deferral of unrecognized gain until December 31, 2026, as such without relief for this provision, taxpayers that want to invest unrecognized gains in QOZ’s must do so prior to December 21, 2021.
- The incoming Biden Administration’s economic plan includes the reform of opportunity zones and other changes to the program. While it is unclear what changes will be made, when taken in conjunction with their recommendation to eliminate the like-kind exchange rules it seems unlikely that this benefit will be extended.
As a result, taking advantage of the benefits now is likely the most certain way to secure a lower tax rate for investments.
Navigating taxes for businesses and individuals of any net worth can be challenging. Whether it is taking advantage of Federal Opportunity Zones or other programs, we’re dedicated to finding the best solution for every client. For additional information, please call us at 248.208.8860 or reach out today. We look forward to speaking with you soon.