With millions of dollars at stake, investors should understand Opportunity Zone tax benefits and multiple levels of regulation, and how they impact the tax benefits of investing in an Opportunity Zone.
This blog covers the basics, including what capital gains can be invested and on what kinds of projects, plus the Treasury’s clarifications made in December 2019.
What is an Opportunity Zone and How Does it Relate to Capital Gains Tax?
There are 8,700 Opportunity Zones in the US, comprising 12 percent of census tracts. Established as part of the 2017 Tax Cuts and Jobs Act, the zones allow investors to offset up to 100 percent of the tax they would pay on Capital Gains by investing that money into Opportunity Funds set up in Opportunity Zones, which are in low-income areas. The program is designed to lure private investment to some of America’s poorest areas, creating jobs, refreshing housing, and supporting industrial renewal.
Those who invest can take advantage of the following Opportunity Zone tax benefits:
- – Immediately, they can temporarily defer tax on Capital Gains monies they plowed into the Opportunity Fund. As soon as the property changes hands, or on December 31, 2026, they are again responsible for the deferred tax.
- – If, however, they keep that money reinvested, they can reduce their tax burden. The basis is increased by 10 percent if the investment is held by the taxpayer for at least five years. At 7 years, it goes up to 15 percent.
- – Investors who hold on to the investment for 10 years or more benefit from permanent exclusion from taxable income on capital gains from the sale or exchange of their investment in the Opportunity Fund.
What Types of Capital Gains Can Be Invested in an Opportunity Fund?
Treasury set out the many types of Capital Gain that are eligible for the Opportunity Zone tax benefits program. Capital gains from the sale of stock, real estate, or any other investment can qualify, and it is based on the individual’s tax responsibility.
Taxpayers have 180 days from the day they made the capital gain to reinvest that money in an Opportunity Fund. The regulations are quite permissive, and cover not just money but allow for property transfer as well – though in some cases the entire property may not be eligible, so do your homework.
What Kinds of Investment Activity are Eligible in an Opportunity Zone?
In order to qualify for the tax incentive, the Capital Gains monies must be invested in a Qualified Opportunity Fund, a partnership or corporation which holds at least 90 percent of its assets in an Opportunity Zone. There are three types of investments that qualify:
- – Partnership businesses that operate in an Opportunity Zone
- – Stock ownership in businesses that conduct most or all of their operations in an Opportunity Zone
- – Assets, including factory equipment or real estate, located in an Opportunity Zone.
Generally, the investment must be a new one. However, Treasury’s clarification in December 2019 said Opportunity Zones can take into account purchased original use assets that otherwise would qualify as business property if the purchased assets:
- – Are used in the same trade or business in the Qualified Opportunity Zone (QOZ) or a contiguous QOZ for which a non-original use asset is used, and
- – Improve the functionality of the non-original use assets in the same QOZ or a contiguous QOZ.
What Opportunity Zone Tax Benefits Have Changed for Investors in 2020
At the end of 2019, Treasury issued a long-awaited clarification that answered a number of frequently asked questions about Opportunity Zone tax benefits. The key changes were:
- – Opportunity Funds can now sell individual properties without having to sell the entire fund.
- – The substantial improvement rules were tweaked to allow a developer to use the construction of a new building to contribute to the improvement of an opportunity zone property where there is already an existing building – for example, by building a community center or gymnasium in an existing housing development.
- – The confusing Section 1231 was clarified so investors can invest gross Section 1231 gains even if they have net Section 1231 losses.
- – The time period for investing gains achieved by selling assets has moved to the sale date rather than the end of the year in which they were sold.
- – Nonresident foreign individuals and corporations can now may Opportunity Zone investments, though only Capital Gains taxable in the US are eligible for the offsets.
- – The clarifications create a working capital safe harbor that gives up to 62 months to complete a project from the first investment date. It is a doubling of the original time frame of 31 months, which developers argued was too tight to get permits, zoning, and other details bedded down.
- – Post-industy “brownfield” sites are considered to be satisfying the Original Use requirement in the Opportunity Zone rules, which makes them easier to develop. Remediation of contaminated land is now considered significant improvement as per the rules.
- – And the clarification sets a 5 percent investment cap in what are termed “sin businesses” – private or commercial golf clubs, country clubs, massage parlors, hot tub or suntan facilities, gambling facilities including race tracks, and liquor stores.