Intro to Opportunity Zones – What are they?
Opportunity Zones and Opportunity Funds were introduced in December of 2017 as a part of the Tax Cuts and Jobs Act with goal of fostering capital investment in areas of the country where capital investment has lagged behind. The Opportunity Zone legislation was a scant 2 pages which required that the IRS further define the details of how Opportunity Zones would work – The IRS continues to provide guidance, with update released in October of 2018, more guidance is expected in Q2 2019. [Note: The IRS provided additional guidance on May 1, 2019. We will provide a summary review in a follow up blog post soon.]
Opportunity Zones are based on census tract geography, and were identified by formula as “low income communities” using the 1986 Section 45D New Market Tax Credit legislation as its basis. Each state was allowed to nominate additional census tracks not to exceed 25% of the original census tracks identified. This process took place over the first half of 2018. All Opportunity Zone geographies was finalized and designated in mid-2018. Here in Minnesota there are a total of 128 Opportunity Zones, of which 50 (40%) are located within Minneapolis/St. Paul ‘s seven county metro area, the majority being in Hennepin and Ramsey County.
What Are The Benefits of Investing in an Opportunity Zone (or Fund)?
The primary benefit of investing in an Opportunity Zone is to avoid capital gains tax. For example, an investor with capital gains from another investment (regardless of asset class) can re-invest those capital gains into an asset located within an Opportunity Zone and defer capital gains tax for 7 years.
Furthermore, if the investment remains in the asset for greater than 5 years then investor gets a stepped-up basis reducing the original capital gain by 10%. If the investment remains in the asset for 7 years, then the investor gets another 5% step-up for a total of 15% reduction in the original capital gain amount. Finally, if the investment remains for 10 years, the capital gain earned on the Opportunity Zone investment is capital gains tax free.
Best way to explain these benefits is with simple walk through of the numbers. Assume an investor sells stock for a $1,000,000 capital gain and invests that gain into an Opportunity Zone investment. If we further assume that the federal capital gains tax is 20% and the seller of the stock paid his/her capital gain in the year incurred, tax would be $200,000. However, if the investor invested the capital gain into an Opportunity Zone investment, the $200,000 tax would be deferred until the earlier of the sale of Opportunity Zone investment sale or 7 years, whichever is earlier. If the investor holds the asset for minimum of 5 years, then tax is reduced by 10% or $20,000. If the investor holds the asset for minimum of 7 years, then tax is reduced by another 5% or a total of $30,000, leaving $170,000 remaining due of the original $200,000 in capital gains tax owed.
This capital gains tax deferral and stepped up basis are nice, but the real benefit of the Opportunity Zone is if the investor holds the investment for 10 years, then the investor does not pay any capital gains tax on the Opportunity Zone investment.
Back to the example - assume the investor buys the Opportunity Zone investment with $1,000,000 capital gain, improves the property with another $800,000 of debt, let’s further assume typical real estate investment with annualized net income at 11% of value, appreciation of net income at 1.5% per year, finally we’ll assume a 10 year investment hold. At the end of the hold, a non-opportunity zone investor would have a capital gain of $1,050,000 and therefore have to pay capital gains tax of $211,000 resulting in after tax average annual return of 8.5% over the term of the investment (note: for this example we are removing the benefits of cash flow). Not a bad return on investment! However, the Opportunity Zone investor would have earned $211,000 in capital gains, but owed no capital gains tax, therefore increasing average annual return to 10.6%, a 25% increase in return!