If you are thinking about selling highly appreciated assets opportunity zones may be a good fit for reinvestment. They may allow you to defer your taxes for a period of time, increase your basis, or exclude capital gains altogether!
Opportunity Zones are defined by the IRS as an economic development tool that allows people to invest in distressed areas in the United States. Their purpose is to inspire economic growth and job creation in low-income communities while providing tax benefits to investors. Any corporation or individual with capital gains can qualify for this federal incentive.
Opportunity Zone Benefits
One major advantage of Opportunity Zones is the ability to defer capital gains by reinvesting into a qualified opportunity fund (QOF). The QOF then invests directly into Opportunity Zones. You can think of this as a similar process to a 1031 exchange for example.
These are like-kind exchanges of similar or identical types of property, but the IRS specifically excludes securities such as stocks and bonds in 1031 exchanges. The Opportunity Zones DO allow for capital gains deferment from stocks and bonds, in addition to the traditional 1031 property types. Furthermore, there can be even greater tax advantages with these QOF funds.
You can receive up to three types of tax benefits when investing in a QOF per the IRS:
- The first is a temporary tax deferral on any capital gains as long as they are reinvested within 180 days after they are realized. Tax payment is deferred until the investment is sold or exchanged, or until December 31st, 2026, whichever comes first.
- If the QOF investment is held for 5 years, you receive a 10% step up in basis for the capital gains reinvested. If held for 7 years, the basis is increased by 5%, totaling a 15% step up. This means once you sell out of the fund any capital gain originally deferred now receives a 15% exclusion from income taxation.
- If held for 10 years, you can PERMANENTLY exclude capital gains. This includes the gains deferred originally and on appreciation made thereafter. This is a massive tax advantage.
Are Opportunity Zones Worth the Investment?
At first glance, the tax savings component is what is so attractive in my opinion. Regarding investment returns, this has yet to be seen and would have to be analyzed more closely case by case.
Obviously, the goal of the Opportunity Zone program is to incentivize people to invest in these distressed areas. The hope would be that these areas are developed, and property values appreciate over time, but that is a separate analysis in my opinion.
The key would be to find these distressed areas that have been certified by the Treasury Department as Opportunity Zones, then you would have to invest in a qualified opportunity fund, which in turn invests into the physical property. A QOF can be a corporation or partnership created for the purpose of investing in Opportunity Zones where at least 90% of its assets are in qualified Opportunity Zones.
In practice, I could see a scenario where a client who sold a large business or commercial property and wanted to defer gains or hold the investment to reach qualify for the tax exclusions, it could be beneficial. You could then have them create a qualified opportunity fund to invest in the opportunity zones or find one that is already established. Having the client start their own would provide more flexibility and opportunity. Finding a QOF already established would be the easier thing to do.
Conclusion
As always, it depends on your situation if it makes sense to invest in opportunity zones. They can provide great tax incentives by receiving lower tax rates or potentially eliminating taxes completely. They could also be a great tool to help with diversification for your portfolio.
Of course taxes don’t matter if the opportunity zone becomes a poor investment by going bankrupt or depreciates significantly in value. This is the risk you run. Always be sure to do your due diligence on the investment such as the QOF. The underlying real estate assets and geographic location should be considered among other criteria such as management and fees/expenses.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at [email protected] or fill out a contact form.
DISCLAIMER
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.