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What is an Opportunity Zone:Tax Benefits & More Explained
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Summary: What is an opportunity zone? Are there opportunity zone tax benefits? Discover the answers to these questions and more as you explore qualified opportunity fund investments in the real estate sector.
Opportunity Zones are a new community development program that was established by Congress via the Tax Cuts and Jobs Act of 2017. The goal of Opportunity Zones is to encourage long-term investments, specifically in low-income urban and rural areas throughout the country, and to inevitably bolster the economy. Not only do Opportunity Zones offer a chance for investors to earn significant revenues, but they also have tax incentives that encourage investors to re-invest their unrealized capital gains into Qualified Opportunity Zones. If all of this is making your head spin a little, don’t worry; the following post will explain all you need to know about Opportunity Zone investment projects and the potential benefits that await.
Where and What is an Opportunity Zone?
The first step towards understanding what an Opportunity Zone is, is to recognize that the Tax Cuts and Jobs Act (TCJA) created this new tax advantaged program to encourage investments in distressed urban and rural communities throughout the country. In this vein, an Opportunity Zone is an economically distressed urban or rural community that has been identified by certain local, state, and federal qualifications. It is important to note that localities can qualify as Opportunity Zones if they have been previously nominated for the designation by the state. If the localities have been nominated, then they will need to be certified by the Secretary of the U.S. Treasury.
Another important component that investors need to understand is the potential to postpone or entirely eliminate taxes on the gains made from Opportunity Zones. While the tax legislation surrounding this new type of tax advantaged program is a bit confusing, what investors do know is that taxpayers can exclude tax on any gains that arise from investing in the associated qualified Opportunity Zone fund, should the fund be held for at least 10 years. This means that both investors and syndicators can stand to benefit from investing in Opportunity Zones. Finally, it is important to note that there are currently over 8,762 designated Opportunity Zones within the United States.
Opportunity Zone Tax Benefits & Incentives for Investors
The government is providing certain opportunity zone tax benefits that wouldn’t normally be available to investors. With this in mind, there are additional benefits associated with Opportunity Zones capital gains tax.
Tax Benefit #1: Temporary Capital Gains Tax Deferral
The first tax benefit that investors can enjoy is a temporary deferral of inclusion in taxable income. This deferral is only applicable for capital gains that are reinvested in an Opportunity Fund. Additionally the deferred gain must be recognized before the opportunity zone investment is disposed of or before December 31, 2026.
Tax Benefit #2: Step-Up In Basis
The second tax benefits that investors can enjoy is a step-up in the basis for capital gains that are reinvested in an Opportunity Fund. It is important to note that the basis is increased by 10 percent should the investment in the Opportunity Fund be held by the taxpayer for at least five years. If the investment is held for at least seven years, then the basis will increase by an additional five percent. In this way, the step-up basis increase can help investors exclude up to 15 percent of the original gain from taxation.
Tax Benefit #3: Permanent Exclusion
The third tax benefit that investors can enjoy is a permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in an Opportunity Fund, should the initial investment be held for at least 10 years. It is important to note that this exclusion only applies to gains accrued after an investment has been made in an Opportunity Fund.
Investor Incentives: Breakdown
Did you know that U.S. investors currently hold $2.3 trillion in unrealized capital gains? These unrealized capital gains represent an untapped resource for further economic development and investment possibilities. In this vein, Opportunity Funds allow investors throughout the United States to use their untapped resources for Opportunity Zone investments. The Opportunity Zone program is designed to incentivize long term investments via the following stipulations.
- Fewer than 5 years. — Deferred payment of existing capital gains until the date that the Opportunity Fund investment is sold or exchanged.
- 5 – 7 years. — The above benefits are enjoyed and 10 percent of tax on existing capital gain is canceled.
- 7 – 10 years. — Deferred payment of existing capital gains until December 31, 2026 or the date that the Opportunity Fund investment is sold or exchanged (whichever comes first) and 15 percent of tax on existing capital gain is canceled.
- Greater than 10 years. — The benefits of 7 – 10 year investment are enjoyed and investors pay no capital gains tax on the Opportunity Fund investment.
It is important to note that all capital gains realized by an investor within 180 days before an Opportunity Fund investment, are still eligible for the tax benefits of investment in Opportunity Funds.
Opportunity Zones vs. 1031 Exchanges: Which Offers Better Tax Incentives for Real Estate Investors?
For many years savvy real estate investors have used the 1031 Exchange for its tax efficient benefits. However, Opportunity Zones are strategically designed to reward long term investment by deferring capital gains taxes. Investors are able to defer their unrealized capital gains by reinvesting the monies earned into an Opportunity Fund. The investors are then taxed on only 85 percent of the original investment, as well as proceeds (if they decide to stay in the fund for up to seven years). If the investment is held for more than 10 years, then the investors are only responsible for paying taxes on the original investment. In many ways, holding onto the investment for more than 10 years is often the more cost effective option.
To further understand the tax benefits of 1031 Exchanges (or like-kind exchanges), it is important that real estate investors understand the associated rules.
- Must be like-kind property.
- No time restrictions, as long as the property is held for investment.
- Tax deferral (however, the investor must eventually pay capital gains).
- Investors can invest anywhere in the U.S.
- Investors must identify the replacement property within 45 days of the sale and close on the new property within 180 days.
- The entire proceeds of the sale must be reinvested.
A Side by Side Comparison
To further understand the differences between the Opportunity Zones and 1031 like-kind exchange, we’ve conducted a side by side comparison looking at the following factors: rollover, qualified assets, investment structure, capital gains tax referral, capital gains tax reduction, and capital gains on final sale.
1031 Like-Kind Exchange
- Rollover. — An investor must identify replacement property within 45 days. The investor must reinvest both the principal and capital gain within 180 days of sale. This transaction can only be conducted via a qualified intermediary.
- Qualified Assets. — The 1031 Exchange can only be completed between like-kind property.
- Investment Structure. — The 1031 Exchange is typically used for single asset swaps. However, you can exchange one property for more than two properties and vice versa so long as the new properties are like your original property.
- Capital Gains Tax Referral. — Capital gains tax payments for the initial investment may be deferred indefinitely. However, if the property is sold, then you will have to pay capital gains taxes.
- Capital Gains Tax Reduction. — No capital gains reduction is available with the exception of a step up in basis upon death of the property owner.
- Capital Gains Tax On Final Sale. — An investor will have to pay capital gains tax on the final sale of the property.
Opportunity Fund Investment
- Rollover. — If an investor wants to qualify for capital gains tax advantages, then they must reinvest capital gains within 180 days of sale. An investor does not have to roll over the entire gain. However, it is important to note that only the rolled over portion will be eligible for tax advantages.
- Qualified Assets. — Capital gains from sale of stock, real estate, or another type of investment can qualify for an Opportunity Fund.
- Investment Structure. — A pooled fund that invests in multiple assets can be used to invest in an Opportunity Fund.
- Capital Gains Tax Referral. — Tax payment on capital gains of the initial investment may be deferred until April 2027.
- Capital Gains Tax Reduction. — Capital gains tax on the initial investment is reduced by 10 percent after 5 years. It is further reduced by another 5 percent after 7 years through step up in basis. In summation, a 15 percent reduction is possible so long as the investor invests by December 31, 2019.
- Capital Gains Tax On Final Sale. — If the investment is held for at least 10 years, then upon the sale of the investment, the investor shouldn’t expect to owe any capital gains tax on any appreciation of the initial Opportunity Fund investment.
Which Option Is Best for You?
How do you decide which option is right for you and your investment strategy? Answering this tough question is made easier with the help of a trusted investor advisor, CPA, and financial consultant. However, to help you begin to contemplate the question, there are a few guidelines that you can follow.
1031 Like-Kind Exchange are typically most suitable for:
- Active real estate investors. These investors should have the resources and / or expertise needed to maintain ongoing management.
- Investors who have already received a gain from a piece of sold real estate or other qualifying asset.
- Investors who do not need to access their principal capital.
- Older investors who plan on leaving any assets acquired through a 1031 Exchange as part of their will.
Opportunity Funds are typically most suitable for:
- Passive investors who want to enjoy the benefits of professionally managed funds.
- Passive investors who are interested in diversifying their portfolios.
- Investors who have already received a gain from an asset sale, such as stocks, bonds, or real estate.
- Investors who want to have access to their invested principal.
- Investors who are planning on selling the investment within their lifetime.
It’s important to note that real estate offers many unique benefits, including tax advantages. Working with a trusted professional can help you to determine the type of real estate assets, and tax-deferred vehicle you should use to maximize your investment opportunities.
Qualified Opportunity Zone Funds
Are you interested in investing in an opportunity zone? If so, you should make the investment via a Qualified Opportunity Zone Funds. With this in mind, it is important to note that as you will read about below, Qualified Opportunity Zones will remain effective through December 21, 2028.
What is a Qualified Opportunity Fund?
A Qualified Opportunity Fund is a U.S. partnership or corporation that will invest at least 90 percent of its holdings in one or more Qualified Opportunity Zones. In this vein, there are three types of investments that can qualify:
- Partnership interests in businesses that operate in a qualified Opportunity Zone.
- Stock ownership in businesses that conduct the majority (or all) of their operations within a qualified Opportunity Zone.
- Property, such as factory equipment or real estate, that is located within a qualified Opportunity Zone.
As the first real estate investment platform to create a simple, low cost way for anyone to invest in real estate, the entire Real Wealth Network is excited about embracing the new investment options that are now available to our members courtesy of Qualified Opportunity Funds. We believe that real estate investments offered under Opportunity Funds can provide new advantages that are not available in most other real estate investments. With this in mind, it is important to note that there are certain requirements and certifications that Qualified Opportunity Funds must meet. Some of these requirements and certifications include:
- Certified by the U.S. Treasury Department.
- Organized as either a corporation or partnership that has the purpose of investing in Qualified Opportunity Zone Property.
- Hold at least 90 percent of their assets in Qualified Opportunity Zone Property.
- Qualified Opportunity Zone property includes newly issued stock, partnership interests, or business property in a Qualified
- Opportunity Zone business.
- Opportunity Fund investments are limited to equity investments in businesses, real estate, and business assets that are located in a Qualified Opportunity Zone.
To become a Qualified Opportunity Fund, an eligible corporation or partnership can use the self certification process. To self-certify, a corporation or partnership must complete the required form and attach that form to their federal income tax return. The return with the attached form must be filed within the established timeline.
Opportunity Fund Pitfalls
Despite the many benefits that Opportunity Funds offer to investors, it is important to note that there are risks associated with Opportunity Zone deals. The key to mitigating associated risks will be to remain diversified, while still taking advantage of the capital gains tax relief available through the program. On the other hand, if investors stay diversified, then there might not be enough funds flowing into these vehicles.
Corporations or financiers interested in investing in an Opportunity Fund should consider that if the program’s new developments and investments in existing businesses spark revitalization in the low-income community, then the investors may reap a windfall. Additionally a single investor will likely not have enough capital gains to make an Opportunity Zone project work. With this in mind, pooled funds may be needed, which creates issues of governance and possible challenges for investors.
The following questions can further help you to understand the ins and outs of Opportunity Zones.
#1. How were Opportunity Zones created?
The Tax Cuts and Jobs Act created Opportunity Zones on December 22, 2017.
#2. Have Opportunity Zones been around a long time?
The short answer is “no.” The first set of Opportunity Zones were designated on April 9, 2018. To date, Opportunity Zones have since been designated to cover areas within all 50 states, the District of Columbia, and five U.S. territories.
#3. What is the purpose of Opportunity Zones?
At their core, Opportunity Zones are an economic development tool. They are strategically designed to spur both economic development and job creation in distressed urban and rural communities throughout the country.
#4. What is a Qualified Opportunity Fund?
A Qualified Opportunity Fund is an investment vehicle. It is setup to be a partnership or corporation, and used to invest in eligible property that is located within a Qualified Opportunity Zone.
#5. Do I need to live in an Opportunity Zone to take advantage of the tax benefits?
The short answer is “no.” To enjoy the tax benefits, you need to invest a recognized gain in a Qualified Opportunity Fund. Next, you will need to elect to defer the tax on that gain.
#6. I am interested in forming a Qualified Opportunity Fund. Is there a list of Opportunity Zones available in which the Fund can invest?
The list of designated Qualified Opportunity Zones in which a Fund may invest can be found at Notice 2018-48.
In conclusion, as their name suggests Opportunity Zones offer a unique investment opportunity for the savvy real estate investor. In order to capitalize on this investment, you should speak with our trusted investment consultant. Additionally, you can review the resources available at Treasury.gov and IRS.gov. Finally, you can join the Real Wealth Network to learn more about Opportunity Zones and our upcoming Qualified Opportunity Fund.
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