OP-ED: It’s An Important Time For Investments In Opportunity Zones
Working with clients interested in opportunity zones has been a wild ride over the last year or so. As we quickly move through 2019, we near what could be an important deadline for many investors. Before getting there, though, let’s take a look back to see how far we have traveled.
Opportunity zones were a seemingly overlooked provision of the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA was signed into law late in 2017, and many practitioners and taxpayers focused on familiar income tax topics, such as rates and deductions. Oregonians closely analyzed the limits on state and local tax deductions.
Hidden in plain view to some were the provisions concerning opportunity zones. Those zones were defined in early 2018, but the laws and regulations surrounding use of their associated tax benefits remained unclear in important respects. The Department of Treasury and the Internal Revenue Service would start issuing guidance in mid-2018, with key releases in the form of proposed regulations occurring in October 2018 and April 2019. The IRS later released “frequently asked questions” in May 2019.
That guidance has gone a long way toward answering – you guessed it – questions that were frequently being asked of me and other practitioners. Opportunity zone funds sprung into existence and noteworthy development projects in Portland have been the beneficiaries of fund investments. And yet, questions remain – often about the fundamentals. So let’s start there.
The opportunity zone tax benefits are primarily three in number. First, taxpayers with qualifying capital gains may defer the tax on those capital gains until 2026. Instead of paying tax now on capital gains realized this year, taxpayers may be able to defer the tax event – and the payment of the tax – until the filing of the 2026 tax return.
Second, taxpayers may be able to reduce the amount of tax owed at that time by obtaining an increase in their basis. Without getting into weeds, it is important to think of “basis” as the nontaxable portion of a taxpayer’s investment. If a taxpayer can increase his or her basis in an investment, he or she can see a reduction in tax associated with the investment.
In the case of capital gains invested in an opportunity zone fund, the taxpayer’s basis is initially zero.
If the taxpayer holds that investment five years, the basis is increased to 10 percent of the amount of gain; and if the taxpayer holds the investment for seven years, the increase is an additional 5 percent to a total increase in the amount of 15 percent. Although we will return to these timing deadlines with respect to this second tax benefit, it is important to note that the increase in basis by 10 percent or 15 percent means the taxpayer will pay less tax in 2026.
The third benefit is complete gain exclusion if the taxpayer holds the investment for more than 10 years. For whatever reason, this third tax benefit has been the least understood by people I have spoken with over the last year or so. Many people believe that holding the investment 10 years means no amount of tax will ever be paid. This is not the case.
Recall the first and second tax benefits about providing for deferral, but only until 2026. Some amount of the gain (85 percent, 90 percent or 100 percent) will be taxable at that time. Do not forget that. Plan for the payment of that tax.
It is only the amount of gain beyond the amount realized in 2026 (plus the applicable basis increase – essentially the total amount of capital gain invested initially) that will be excluded from future gain. In other words, do not let the allure of the third tax benefit obscure the realities of the first two tax benefits.
Additionally, bear in mind 2019 is seven years before 2026. If you want to maximize that second benefit (namely, the 15 percent basis increase), this is the year by which you need to harvest capital gains for investment in an opportunity zone fund. Heading into the end of the year, developers are likely to be presented with more sources of investment capital as opportunity zone fund investors look to deploy funds to meet the timing deadlines.
Although much of the “rush” associated with opportunity zones has settled in the past few months, I anticipate that to change between now and 2020. The three tax benefits described above will continue to drive interest and investment in opportunity zones. Let me know what you are hearing out there – I would be interested in learning about your experiences and hearing your stories.
Column first appeared in the Daily Journal of Commerce on August 28, 2019.