Sounds too good to be true, right? Over the past nine months, I have received calls from a number of my clients asking about a new investment opportunity being pitched to them. Whether it was a downtown York restaurant or an apartment complex in Baltimore, a primary draw of these investment opportunities was the potential tax savings. Many of these clients I would label “sophisticated investors,” so they are all well aware of various investment and tax-deferral strategies, such as 1031 like-kind exchanges. But permanent tax abatement? That almost seems too good to be true.
When President Trump signed tax reform into law in December 2017, he enacted this new tax incentive. At first, federal opportunity zones were widely overlooked as many other tax reform provisions such as the C Corporation rate reduction, the 20 percent qualified business income deduction and the $10,000 state and local tax deduction limit received national attention. As we moved into spring, however, attention turned to opportunity zones as investors began to realize just how good of an incentive they could be.
Opportunity zones can help stimulate economic and community redevelopment, but I’m a tax guy so I want to share why it makes sense from a tax standpoint. This is where I may lose some of you, but hey, the tax incentives are really what is going to drive this redevelopment forward.
There are three different tax scenarios at play with opportunity-zone investments: a tax deferral on capital gains tax, a partial permanent abatement of capital gains tax and a full abatement of capital gains tax.
The tax deferral piece relates to the unrecognized capital gain on property (such as real estate, stocks or artwork) that a taxpayer disposes of and within 180 days reinvests into a qualified opportunity fund, similar to a 1031 like-kind exchange.
The taxpayer can now defer paying capital gains tax on this original investment until the earlier of: 1) the date of the disposal of the investment in the qualified opportunity fund, or 2) Dec. 31, 2026. One important difference with an opportunity-zone deferral compared to a 1031 exchange is that for opportunity zones, only the deferred gain must be reinvested, not the entire proceeds from the sale. This will allow investors to reserve some cash upon their disposition of the original investment for future taxes when the deferral period ends. This becomes important as we discuss the benefits of holding onto the qualified opportunity fund beyond the deferral period.
There also is a potential partial permanent abatement of capital gains tax for the original investment that was sold. If the taxpayer holds onto the subsequent qualified opportunity fund for five years, 10 percent of the capital gain on the original non-qualified opportunity fund investment is abated. If held for seven years, a total of 15 percent of the capital gain is abated.
Since the deferral period ends on the earlier of the qualified opportunity fund disposal or Dec. 31, 2016, there is incentive to invest in these qualified opportunity funds now to take advantage of this partial abatement of capital gains.
Lastly, there is a 100 percent abatement of all capital gains tax associated with the qualified opportunity fund investment itself as long as the investment is held for more than 10 years. This is where the real tax savings can occur if the qualified opportunity fund is successful.
Let’s walk through a brief example to show how this all plays out:
• An investor sells a multi-unit residential rental property for $1 million. The investor realizes capital gains of $300,000. Within 180 days of the sale, the investor reinvests that $300,000 capital gain into a qualified opportunity fund, deferring capital gains tax. He keeps $700,000 of cash from the deal.
• The investor holds onto the qualified opportunity fund for 12 years, and then sells his share of the investment for $750,000.
• Prior to this, on Dec. 31, 2026, the investor recognized capital gains tax on $255,000 of capital gains from the original non-qualified opportunity fund investment. $45,000 (15 percent) of gain was permanently abated, since the taxpayer held onto the subsequent qualified opportunity fund investment for more than seven years.
• Lastly, since the investor held onto the qualified opportunity fund for more than 10 years, his $450,000 of capital gain is fully abated upon his sale of the qualified opportunity fund.
• In total, the investor was able to abate $495,000 of capital gains and enjoy a tax deferral along the way.
What have I been telling my clients about federal opportunity zones?
It is potentially one of the best tax incentives out there due to the combination of tax deferral and permanent tax savings, but as with all tax-planning strategies, do not let sound investment practice be overruled by tax incentives.
There will certainly be a number of qualified opportunity funds that do not pan out for investors, so careful analysis of a qualified opportunity fund’s objectives is key before investing. And beyond the financial and tax aspects of the federal opportunity zones, let’s hope these special investments really do spark the revitalization efforts in our surrounding communities that they are intended to do.
Michael J. Eby is a partner in the tax services group of RKL LLP in Harrisburg. He can be reached at [email protected].