If you love paying taxes, you won’t want to read this post. On the other hand if you’re staring down the barrel of looming capital gains, whether from the sale of real estate, stocks, bonds, or interest in a partnership, this could be the opportunity that you’ve been searching.
The Tax Cuts and Jobs Act of 2017 created an excellent tax advantage for real estate investors. To encourage the improvement of economically-disadvantaged areas, the federal and state governments have designated certain census tracts as Opportunity Zones (OZ). Investing your capital gain into an Opportunity Zone will allow you to defer payment of the tax and potentially reduce the amount owed.
How does it work?
- You sell a capital asset at a profit and receive what’s called ‘capital gains’. Capital assets include real estate, stocks, bonds, and ownership interest in a partnership.
- Within 180 days, you invest in or create your own Qualified Opportunity Fund (QOF). This is a fund created with the sole intent of investing in “qualified opportunity zone property.” At least 90% of the fund’s assets must be invested in OZ.
- The fund substantially improves the property within 30 months of its purchase. The investment must equal or exceed the amount allocable to the original purchase price of the building(s) on the land. So if the building is worth $1MM when you buy it, you have to put another million into improving it. Cost of the land is not included in the calculation.
- You wait. After holding your money in the fund for 5 years, there is a 10% exclusion of the deferred gain. After 7 years, the exclusion goes up to 15%.
Here’s an oversimplified example: you bought a property for $100,000 and sold it for $220,000. Normally, you’d pay capital gains tax on $120,000: the difference between selling and purchase prices.
If instead, you invest the capital gains of $120k into a QOF, after 5 years 10% of the $120k is excluded so you’d only owe tax on $108k and after 7 years, you’d only owe tax on $102,000.
- Your capital gains tax — now potentially reduced by 15% — is deferred until December 31, 2026, assuming you don’t sell. If you liquidate the assets of the QOF before 12/31/2026, taxes would be due as of the sale date.
- You wait a little longer. After 10 years, any profit that you’ve made by investing in the QOF is now tax exempt.
To be clear, you potentially save money in two ways with OZ: you save up to 15% of the capital gains tax on the asset that you sold to get into the fund and you save the tax you would have paid on the profit when you sell the building that you buy and improve with the QOF.
What are Opportunity Zones and where can I find them?**
- These maps will help you find OZ in your area: US Mass
- OZ have certain criteria in common: an area must either have an individual poverty rate of at least 20% and median family income of no more than 80% of the median income for the area where it is located or border an area that meets those criteria.
- In April 2018, the US Treasury Department certified more than 8,700 opportunity zones. Each state, territory and Washington DC recommended areas for consideration. No more than 25% of areas that met the criteria could be included in each district.
- Note: if you invest in someone else’s QOF instead of starting your own, be sure to verify that the goals of the fund managers align with your own. If the fund won’t be around at least 10 years, you won’t be maximizing your return. Likewise if the fund invests in areas that don’t show significant gain, your 10-year profit will be lower or nonexistent.
- You don’t need to live in an OZ to benefit from investing there
- IRS form 8949 should be filed if you’re planning to invest your capital gain into a QOF.
- Property and other non-cash assets can be transferred into a QOF but consult a tax specialist if you’re thinking of doing this. It’s possible that only a portion of the value of the transferred asset may be eligible for tax deferment.
- OZ are new and some issues are still a bit sketchy. Be sure to consult a tax specialist well-versed in OZ and QOF before proceeding. Time and being tested in court will eventually iron out the exact guidelines.
Compared to a doing a 1031 Exchange with your capital gain:
- Pro: unlike a 1031 exchange, you don’t need to decide before selling your asset. As long as you invest within 180 days, you’re good. If you’ve filed taxes in between, you’ll have to do an amended return.
- Pro: unlike a 1031 exchange, only the capital gain — not the entire asset value — must be invested in the QOF.
- Con: you will pay some capital gains tax although payment is potentially deferred until 2026.
- Pro: after ten years, you can sell the asset or liquidate the fund and get your cash. A 1031 exchange has to stay invested or be taxed.
- More about 1031 exchanges here
When evaluating a QOF or potential OZ investment, look for scenarios where the numbers work even without the tax advantages. Don’t let enthusiasm about the potential savings blind you to the economics. Consider the future growth potential of the area and its economic prospects. Factor in zoning and infrastructure as well as any local government plans to improve service offerings and community engagement. Also remember that this is a long-term investment. If there’s a chance you’ll need this money in less than 5 years, this may not make sense for you.
On the other hand, if you need a place to park some money until your retirement or if you have funds slated for long-term investing, a QOF could be a great option. Turns out the yellow brick road is made of gold bars, follow it to OZ.
*According to UrbanCatalyst.com, gains taxed as ordinary income and gains from certain derivative contracts are not eligible for qualifying investment.
**Some information compiled from Realtor Magazine, March/April 2019 issue
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