It’s been said no one goes broke selling investments for gain. However, they are likely to trigger a costly tax event, a reality that leads many U.S. taxpayers to hold onto appreciated investments longer than they would prefer.
A beneficial tax provision added to the 2017 Tax Cut and Jobs Act (TCJA) encourages the sale of these appreciated assets. It offers sellers the ability to defer, reduce and even, under certain circumstances, eliminate a portion of the inevitable tax bite from capital gain.
Enter the Opportunity Zone
To qualify for the tax benefit, taxpayers are required to reinvest their capital gains in a Qualified Opportunity Fund (QOF). The QOF then invests in business development projects within Opportunity Zones.
There are more than 8,700 of census tracts that have been designated as Opportunity Zones across all 50 states, the District of Columbia and Puerto Rico. In addition to suburban and rural communities, nearly every major U.S. city has multiple Qualified Opportunity Zones, and many of the areas are ripe for investment
Not just a benefit, a triple tax benefit
There are three different tax benefits that may result from reinvesting a capital gain—whether long-term or short-term—in a QOF.
- Gain deferral - Taxpayers can defer the gain until the qualifying investment is sold or exchanged or until the mandatory recognition date or December 31, 2026 at the latest.
- Partial gain forgiveness - If the qualifying investment is held for five years before it is sold or reaches the mandatory recognition date, only 90% of the original gain will be recognized. Investments held for seven years receive another 5% step up in their cost basis, requiring the taxpayer to recognize only 85% of the original deferred gain.
- Tax-free future appreciation -- If a QOF investment is held for 10 years, no additional gains beyond the original deferred gain recognized in 2026 (with as little as 85%) will be recognized as being taxable when the interest in the QOF is eventually sold. This makes any appreciation since the original investment in the QOF essentially tax-free.
While the tax deferral and reduction in the liability are attractive, the third benefit, the ability to shelter any subsequent gain on the sale of the reinvestment has many taxpayers considering QOFs… or considering becoming one.
What is a QOF?
Any partnership or corporation, including real estate developers and operating businesses, can become a QOF by self-certifying. It involves a one-page form. However, the QOF’s activities must be structured in specific ways to qualify for the tax benefits. That is not as simple as it sounds.
TCJA left many of these specifics undefined. Even with the clarifications
released by the IRS in mid-October 2018, the regulations are still a work-in-progress. A second round of rulings is expected in the first quarter of 2019, after which activity in this area is expected to accelerate.
What is known
Here are some of the details that are known about QOFs. They will help you plan as you start to identify situations where Opportunity Zone investing may make sense.
Opportunity Zones as a Like-Kind Exchange alternative
- The deferral of the capital gain into a QOF must be made within 180 days after the sale or exchange that created it.
- Whether it is being made by individuals, corporations, partnerships, REITs, RICs, trusts or an estate, the election to defer gain is made using Form 8949, which needs to be attached to the income tax return.
- Since the mandatory recognition date for the original investment of the gain is December 31, 2026, the investment must be made before year-end 2019 to receive the 7-year basis bump.
- Because the election for the basis increase after 10 years is not available for amounts invested in a QOF that exceed the amount of the actual gain deferred, there is no benefit to investing additional amounts in a QOF.
- A QOF must have 90 percent of its assets in qualified Opportunity Zone property.
Opportunity Zone investing bears some similarities to like-kind exchanges and in some circumstances, taxpayers may find a like-kind-exchange to be more beneficial. However, there are several key differences. Below is a side-by-side comparison to help determine which is the right vehicle for a given situation.
Illustrating the potential benefit
Consider a taxpayer with $1 million in long-term capital gain in 2018 and assume the taxpayer can achieve the same 5% annual rate of return by investing either in a QOF or an outside investment.
If the taxpayer pays tax at the top marginal rate of 23.8% (20% rate for long-term capital gains and 3.8% net investment income tax), the taxpayer could invest only $762,000 outside the fund after tax. By investing in the fund, the taxpayer defers the gain and can invest the entire $1 million.
The taxpayer will pay tax on the $1 million in deferred gain on Dec. 31, 2026. Because the investment was held for seven years, the taxpayer will only recognize 85% of the gain and will pay only $202,300 in taxes. This money has to come from outside the fund, so we will estimate that the true “cost” of this tax is $223,036 because the taxpayer loses the ability to earn a 5% rate of return on that amount for the two years between when it is paid and the asset is sold.
After 10 years at 5% growth the original $1 million invested in the QOF will be worth $1,628,895. No further gain will be recognized on the sale, so the only tax cost is the $223,036 for the recognition event in 2026. The net after tax proceeds are $1,405,859.
The $762,000 invested outside the fund has only grown to $1,241,218 and the taxpayer must pay $114,054 in tax on $479,218 in gain when selling after 10 years. The taxpayer has netted only $1,127,164, or $278,695 less than if the taxpayer had invested in the QOF!
This is a simple example that ignores state taxes, does not account for any income recognized while the investments are held, and assumes equivalent rates of return. It should not be considered a guarantee of return or benefit, but does offer a basic illustration of the potential power of the tax incentive.
What you can do now
With the final rules expected within the next few months, it’s a good time to review assets and consider the potential savings that participating in a QOF offers, especially if it can be arranged prior to year-end 2019.
To stay informed as the details are released, visit Grant Thornton’s Tax Reform
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