The 2017 Tax Cuts and Jobs Act created the Opportunity Zones program to generate long-term investments in low-income neighborhoods. With qualified opportunity zone tax benefits, the federal government aims to encourage investors to take advantage of the investment vehicle and help the disadvantaged census tracts.
Here, Lilypads discusses some of the qualified opportunity zones that offer several tax benefits to investors.
These include tax deferral, the step-up basis for capital gains, and capital gains exclusion.
The IRS states that both capital gains taxes and qualified section 1231 gains Can be deferred through investments in qualified opportunity zone funds.
However, they must be reported in an investor’s federal income tax returns by January 1, 2026.
Read Lilypads’ detailed article on Opportunity Zones here.
1. Tax deferral
This helps investors to enjoy tax-deferred gains for a temporary period.
Opportunity funds allow investors to defer taxes on their invested capital gain until December 31, 2026.
They can also avoid taxation on the gain from the sale or exchange of any property to an unrelated person.
For such a qualified opportunity zone real estate tax benefit, the investors must reinvest their capital gain proceeds into a qualified opportunity fund within 180 days of selling or exchanging their prior investments and achieving the gain.
The first day of the 180 day period is the date the gain is recognized for federal income tax purposes.
However, the IRS has now made certain changes due to various problems.
Now, if the 180th day to invest in a qualified opportunity zone fund is on or after April 1 2020 and before December 31, 2020, the investor can have the gain invested before December 31, 2020.
2. Step-up basis for capital gains is one of the primary opportunity zone tax benefits
- If an investor invests money in a qualified opportunity fund on or before December 31, 2021, and locks the investment for over 5 years, they can reduce their capital gains tax liability by 10% for the original capital gain.
So, they receive a 10% step-up in tax basis after five years.
- If the investor invests on or before December 31, 2019, and holds the investment for 7 years by the end of 2026, they can reduce their tax liability by 15%.
However, to receive the entire 15% step up on a tax basis, the investor must have invested by December 31, 2019.
Hence by the end of 2026, the investor will have held the investment in the quality qualified opportunity fund for seven years.
Therefore they can be eligible for a 15% decrease in the taxation of their original investment.
3. Permanent tax deferral
Investors seeking to eliminate capital tax gains completely must hold the investment for a period of 10 years until December 31, 2047.
Hence, they pay zero dollars in capital gains taxes on any appreciation that their opportunity zone fund investment achieves.
Besides, the cost basis of the property becomes equal to the fair market value on the date of sale/exchange.
So, the investor has to make an affirmative election to defer taxes.
4. Substantial improvements
The IRS requires that investors must make “substantial improvements” to the properties to receive qualified opportunity zone fund tax benefits.
Hence, improving properties and the communities of an opportunity zone remains the core purpose of this investing vehicle.
So, a QOF must double the adjusted basis in the property after acquiring it. They can also achieve the threshold at the beginning of any 30 month period that they hold their property.
In addition to this, some opportunity zone census tracts may have their own thresholds. This includes a separate tax credit for affordable housing.
Numerous factors determine how much a qualified opportunity investment is entitled to tax benefits. These factors include:
- The amount of investment
- The time period for which the investment is held in
- Overall income from the investment
- Returns received from the opportunity fund
What are the other benefits of opportunity zone investments?
Besides tax advantages and incentives, there are several additional benefits to opportunity zone investments including:
- Investors can diversify their portfolios with real estate assets as well as local start-ups and businesses.
- Investing in a diversified multi-asset qualified opportunity fund provides a stable revenue stream to the investors.
- With opportunity funds, investors can now contribute to the social upliftment of economically underserved areas and their communities.
What are the risks of opportunity zone investments?
- Opportunity zones lack the infrastructure to support large-scale business expansion. Hence, investors must conduct their due diligence regarding the location, market analysis, and community stability of the said area.
An investment in an economically distressed area can be risky due to the chance of losses. So, the investors should study the success record of the investment manager in non-opportunity zones.
Therefore, they can reduce the risk of partial or complete loss of investment principal.
- Opportunity funds require the investors to tie up a significant amount of capital for a long period to gain the tax benefits.
Such a lack of liquidity may not be suitable for investors who may face sudden cash requirements.
- In the opportunity zones, business properties may have faced their ultimate appreciation prior to the opportunity fund investments.
Furthermore, a real estate project may not be viable for the local community and their requirements.
In such cases, there is little room for profits remaining for the investors after the high costs of investments that cancel out the tax benefits.
The Lilypads Bottomline:
Opportunity Zone tax benefits make real estate investments a lot better
Ultimately, opportunity zones tax benefits can be highly lucrative for real estate investors to build tax-free wealth and also help underprivileged communities to prosper.
However, just like any investment, opportunity zone investments require proper research and risk tolerance on the part of the investors. Nonetheless, opportunity zone investment is a positive step towards revolutionizing the real estate industry.