In December of 2017, Congress established one of the greatest tax incentives in United States history under 26 U.S.C. 1400Z-1 and 26. U.S.C. 1400Z-2, known as “the Opportunity Zone Program”. The program promotes community development and economic vitality in certain low-income communities throughout the United States and Puerto Rico (“Opportunity Zones” or “O-Zones”) through investment in a qualified corporation, partnership, or limited liability company (“Opportunity Fund”). Substantial cash-flow into these areas is expected over the next decade.
Here’s how it works: First, an investor who sells off a current investment (i.e., stocks, property, etc.) can defer payment of taxes on her capital gains until as late as December 31, 2026 by re-investing those deferred gains within one hundred eighty (180) days into an Opportunity Fund. The fund, in turn, must invest at least ninety percent (90%) of the its assets into a business or property located in an Opportunity Zone. The investor will receive a “step-up” in basis on the deferred gains in the amount of ten percent (10%) of the deferred gains, if held in the Opportunity Fund for five (5) years, or fifteen percent (15%) of the deferred gains, if held in the Opportunity Fund for seven (7) years. The deferred gains, then, are probably taxable upon their divestiture; note, however, that federal guidelines regarding the mechanics of this component are forthcoming.
Upon the sale of investments held in an Opportunity Fund for at least ten (10) years, the investor’s tax basis on those amounts will be equal to its fair market value as of the date of the sale. In other words, capital gains accrued from the activity of the Opportunity Fund will be entirely non-taxable and the investor saves amounts that would be otherwise taxed at a rate of up to twenty percent (20%).
Let’s consider an example. Suppose Charlie sells stock, originally purchased for $100,000, for $1,000,000. Upon the sale, Charlie pays taxes on her capital gains of $900,000. Since these capital gains are likely taxed at a rate of twenty percent (20%), Charlie pays her capital gains tax of $180,000 and is left with $820,000. [$100,000 + ($900,000 – (20% X $900,000)) = $820,000.] If Charlie reinvests her $820,000 by purchasing Property A for $820,000, which she then sells for three (3) times the purchase price, ten (10) years later, Charlie has $2,460,000. After her capital gains taxes from the sale of Property A are paid, Charlie has $2,132,000. [$2,460,000 – (20% X ($2,460,000 – $820,000) = $2,132,000.]
Now let’s consider what might happen if Charlie’s real estate acquisition utilizes the tax benefits of the Opportunity Zone Program. Here, when Charlie sells her stock, her capital gains taxes are deferred. Instead of mobilizing those funds to pay her taxes for the year, she sells her stock. Charlie then reinvests her deferred gains and principal into Charlie’s Opportunity Fund, LLC. Charlie’s Opportunity Fund, LLC deploys one hundred percent (100%) of its assets by purchasing Property B, which is located in an Opportunity Zone. The result is that Charlie has invested $1,000,000, indirectly, into real estate. If the fund sells Property B for three (3) times the purchase price, ten (10) years later, Charlie has $3,000,000 before taking capital gains taxes into account, including her: (i) original investment of $100,000; (ii) deferred capital gains of $900,000; and (iii) capital gains, from the activity of the fund, in the amount of $2,000,000.
Because she held her deferred capital gains in an Opportunity Fund for seven (7) years, Charlie’s tax basis is “stepped-up” from $100,000 to $235,000, so the taxes owed from her original investment total $153,000 (instead of the $180,000 she paid in the first example). [20% X ($1,000,000 – ($100,000 + ($900,000 X 15%)))] Furthermore, because Charlie held her investment in an Opportunity Fund for ten (10) years, the capital gains from the activity of the fund, “normally” taxed at twenty percent (20%), are not taxed at all. Instead of ending with $1,968,000, Charlie has $2,847,000. [$3,000,000 – $153,000 = $2,847,000.]
In both of the above scenarios, Charlie sells an investment worth $1,000,000, reinvests the full amount of her principal, capital gains, and deferrable capital gains taxes into real estate. She also retains her position in Property A and Property B for ten (10) years and sells each for three (3) times the purchase price of each property, respectively. In the first, “traditional” scenario, Charlie’s net gain is $1,132,000. However, by utilizing the advantages of the Opportunity Zone Program, as demonstrated in the second scenario, Charlie’s net gain is $1,847,000 – a difference of over sixty-two percent (62%). Savvy real estate investors will be attracted to extensive advantages offered through the program.
It’s important to note that many aspects of this program have yet to be addressed and additional information is forthcoming from the federal government, expected by October 2, 2018. A map of Colorado’s Opportunity Zones is available at choosecolorado.com/opportunityzones. Other Opportunity Zones are located throughout all fifty (50) states and Puerto Rico, including parts of (i) Brooklyn, New York; (ii) Portland, Oregon; (iii) Houston, Texas; (iv) Los Angeles, California; and (v) Seattle, Washington. For more information and to receive updates from The Horowitz Law Company, follow us on Facebook, at facebook.com/HorowitzLawCo, on Twitter, at twitter.com/HorowitzLawCo, and on Instagram, at Instagram.com/HorowitzLawCo. Updates are also posted our website, horowitzlawco.com.
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