The 2017 Tax Cut and Jobs Act created Opportunity Zones. These special economic zones give investors and business-owners a chance to do some good in a depressed area, make some money, and obtain some significant tax benefits. That is a pretty powerful combination.
For this reason, OZ investments have a significant edge over traditional 1031 exchanges. If owners exchange one investment property for another, they may reap some capital gains tax breaks. But 1031 exchanges only apply to real property, OZ investments apply to any capital asset. Additionally, 1031 tax breaks usually only apply when the owner dies.
However, unlike 1031 exchanges, which are rather straightforward, there are a number of intricate rules concerning OZ investment tax breaks. A certified tax coach has the tools you need to maximize these benefits.
The Basics of Opportunity Zone Investments
There are more than 8,500 opportunity zones throughout all fifty states and Puerto Rico. Most, but not all, of them are in the South and Mountain West. The IRS will certify an area as an Opportunity Zone if:
- The state or territorial government nominates it, and
- The area has a 20 percent or higher poverty level, or
- Median household income is at least 20 percent lower than the nearby areas.
In practical terms, these numbers mean that Opportunity Zones are usually not hopelessly depressed areas. Many times, they are downtown neighborhoods that need a redevelopment jump-start. Other times, they are places where suburban sprawl is approaching, but has not quite arrived yet.
Types of Investment Opportunities
In general, either people or companies can invest in Qualified Opportunity Funds. A QOF directs invested funds into the Opportunity Zone. This setup decreases investor risk and helps ensure that more money goes to the Zone itself. In fact, in most cases, at least 50 percent of the QOF’s revenue must come from the OZ, and at least 90 percent of investors’ money must go into the Zone.
Some QOFs are direct funds. These entities operate businesses inside the OZ. Some vice or sin businesses, like massage parlors and liquor stores, are not eligible for OZ status. Other QOFs are indirect investment funds. The investor buys an equity interest in the QOF, which then reinvests this money into an Opportunity Zone business. According to complex IRS rules, at least 63 percent of all indirect investments must go to Qualified Opportunity Zone Business Property. That’s a good thing if, as is often the case, the QOF is a diverse, multistate entity. Some additional safe harbor provisions give indirect investors even more flexibility.
As mentioned, OZ tax benefits generally involve capital gains tax breaks. The three major ones are:
- Deferral: Investors need not pay capital gains tax on any Opportunity Zone investment property until 2027 or until they sell or exchange any portion of the investment.
- Exclusion: Lawmakers want to encourage long-term investment in these areas. So, investors who keep their money in the OZ for at least five years may exclude 10 percent of their capital gains tax. That exclusion increases to 15 percent after seven years.
- Basis: This tax break is probably the big one. If investors hold the capital asset for more than ten years, the IRS calculates basis on the date of sale as opposed to the date of purchase. So, the investor basically pays no capital gains tax on the property’s increased value.
State tax rules may or may not be the same. So, it may be necessary to track the investments separately to maximize tax benefits.
To learn more about this tax break, and others like it, contact a certified tax coach near you.
Call us today at 855-693-7829 to schedule your free consultation. As a thank you for scheduling your consultation, we’ll provide a free book, The Great Tax Escape.