In today’s political climate, the swinging pendulum of regulation vs. deregulation can be difficult to track. Yet sometimes government programs are put into place which can truly benefit both investors and the community. When Opportunity Zones were implemented as part of the Tax Cuts and Jobs Act of 2017, real estate investors were incentivized to invest and/or reinvest into low income areas through tax breaks including deferred capital gains, eliminated capital gains, and/or cost basis changes.
While the full tax benefits of Opportunity Zones will be lost starting in 2020, the program will remain in effect. Here’s how it works.
What are Opportunity Zones and Opportunity Funds?
All investors know the pain of capital gains tax. At its core, cap gains taxes are taxes paid on the net gain of an investment. A common example would be buying and selling stocks. If an individual purchases $1,000,000 in stock and later sells that stock for $1,500,000, he or she would be responsible for paying taxes on a capital gain of $500,000. Traditionally, the best way to avoid paying capital gains tax was to defer payment through reinvestment.
The Opportunity Zone program takes this idea and builds upon it. Let’s take the above example. Instead of collecting the full $1.5 million after selling this asset, the investor could instead reinvest the funds into an Opportunity Fund. It is important to note that to be eligible for tax breaks, this individual would only be required to invest the gains, not the full amount.
Opportunity Zones are Defined as an Economically Distressed
In order for a real estate reinvestment to qualify for Opportunity Zones tax breaks, it must be determined that the real estate falls within a designated Opportunity Zone. The IRS defines an Opportunity Zone as “an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity ZELASTO_Media Report_052518.pdf ones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.”
Qualified Opportunity Fund Reinvestment
The other key component of the Opportunity Zone Program is participation in a qualified Opportunity Fund. It is not enough to simply reinvest capital gains into an Opportunity Zone community. Reinvestments must be made through the program. If these steps are followed, the initial investment gains and any gains made through the subsequent reinvestment within the Opportunity Zones Program may be eligible for significant tax breaks.
One of the first Opportunity Zone projects in the Pittsburgh region, the construction of a 60,000 square foot indoor growing facility in Braddock for Robotany, will soon become one of the first projects to complete the investment cycle. Developer RDC Design + Build is nearing an agreement to sell the project to a permanent investor that will have the opportunity to reap the long-term tax benefits.
Opportunity Zones, Property Investments, and Capital Gains
There are four basic scenarios which can play out when an investor participates in an Opportunity Zone reinvestment:
- If the investor sells the reinvested property in less than five (5) years: he or she will be responsible for paying capital gains tax at this time. Even without receiving the full tax benefits, this scenario does allow for tax deferment until the fund is sold or until December 31st, 2026 — whichever comes first.
- If the Opportunity Fund investment is held between five (5) and seven (7) years: the full capital gain amount is deferred plus a 10 percent bump in cost basis. In our example, that would equal a saving of $100,000.
- If the Opportunity Fund investment is held between seven (7) and ten (10) years: In addition to capital gains deferment, the cost basis is bumped a total of 15 percent, totalling a savings of $150,000 in our example.
- If the Opportunity Fund investment is held for ten (10) or more years: the investor is responsible for paying nothing on the appreciation of the reinvested asset. This means that through the Opportunity Funds Program, it is possible to invest in real estate with zero liability for capital gains taxes on net gains.
2020 Changes to Qualified Opportunity Zone Funds
As one last point, time is running out for investors to reap the full benefits of the Qualified Opportunity Zone Program. As of January 1st, 2020, the maximum cost basis deferment will shift from 15 percent to 10 percent. While this does not take away from the other benefits of the program, that 5% cost basis differential can equate to huge dollar volumes for investors. Despite this, real estate investors are always cautioned to never rush into a real estate investment to get under a time limit or deadline. The right investment with a slightly higher cost is likely more profitable that the wrong investment at a slightly lower cost.
With current regulations, Opportunity Zones and Opportunity Funds continue to be a great choice for real estate investors through 2019. However, starting in 2020, that appeal is somewhat diminished by lessened tax incentives. This may cause some real estate investors to panic and make unwise investments. We would caution that a smart investment is a smart investment and a poor investment is a poor investment. When it comes to real estate, a tax incentive should be viewed as the cherry on top, not a reason to invest.
Rather than rushing to make an Opportunity Zone investment before year’s end, going through your usual due diligence is almost certainly the right decision. Whether that misses the 2019 end-of-year cutoff or not, your interests will be better secured.