Opportunity zones could be the single biggest tax break in decades, but the topic is not yet well known to many CPAs, and that lack of knowledge could end up costing your clients millions.
The Tax Cuts and Jobs Act, passed by Congress in the final days of 2017, introduced transformative changes to key areas of the Tax Code, many of which garnered a great deal of attention in the media and the professional accounting community. The TCJA also created the lesser known IRC Sections 1400Z-1 and 1400Z-2, which could have an enormous impact both on your clients’ tax liability and on economically distressed communities throughout all 50 states of the U.S. The new Opportunity Zone program, which consists of Opportunity Zones and Opportunity Funds, has the power to accomplish this. At a high level, the goal of opportunity zones is to promote investment of the estimated $6.1 trillion in unrealized gains held privately in the U.S. into the development of low-income communities across the country in exchange for federal tax advantages only available through the new Opportunity Zone legislation.
What are Opportunity Zones and Opportunity Funds?
As outlined in Section 1400Z-1, Opportunity Zones are census tracts generally composed of economically distressed communities. The census tracts are nominated by state governors and the mayor of the District of Columbia and certified by the Department of the Treasury. Up to 25 percent of census tracts in each state and the District of Columbia that meet the qualification requirements defined in Code Section 45D(e) are eligible. Areas certified as qualified opportunity zones retain their designation for 10 years, and to date, there are more than 8,700 qualified opportunity zones in the US. Code Section 1400Z-2 goes on to define opportunity funds as investment vehicles that aim to invest at least 90 percent of their capital into “qualified opportunity zone property,” which is defined as qualified opportunity zone stock, partnership interest, or business property located in designated census tracts. Investors have 180 days to roll a capital gain into a qualified opportunity fund in order to realize several important tax benefits:
A temporary tax deferral for capital gains reinvested in an opportunity fund. The deferred gain must be recognized on the earlier of the date on which the opportunity zone investment is sold or Dec. 31, 2026.
A step-up in basis for capital gains reinvested in an opportunity fund. The basis of the original investment is increased by 10 percent if the investment in the qualified opportunity zone fund is held by the taxpayer for at least five years. It is increased by an additional 5 percent if held for at least seven years, thus excluding up to 15 percent of the original gain from taxation.
A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund, if the investment is held for at least 10 years. This exclusion applies to the gains accrued from an investment in an opportunity fund, and not the original gains invested into an opportunity fund.
To see exactly how much more an investor can save, compare a $100,000 capital gain rolled into a traditional stock portfolio versus an opportunity fund both earning a 7 percent annual return. After ten years, net of taxes, the total return on the stock portfolio would be 32 percent. Meanwhile, the net, after-tax return on the opportunity fund investment would be 73 percent. On an after tax basis, opportunity funds could mean a two times higher return on investment as compared to a traditional stock portfolio. As you can imagine, such potential return premiums are attracting interest throughout the investor community.
While there are still some unanswered questions on opportunity zones, the rules and processes are designed to be straightforward with minimal friction. Opportunity funds not only provide exceptional tax benefits, but also hold the promise to be simpler, lower maintenance, and less expensive than alternative tax incentives like tax credit programs and 1031 exchanges. The provision is more of a tax election, rather than a tax program, and that should ease the burden on investors.
The unique appeal of opportunity funds
It is important to note that opportunity funds are not just for real estate clients. Gains from the sale of stock, a company and even cryptocurrency can be rolled into an opportunity fund. Did your client sell their business this year? Are they currently working through estate planning? Are they attempting to finally exit a 1031 exchange and get access to principal after years of exchanging? This tax legislation could be a cornerstone of a client’s tax planning strategy.
It is critical that CPAs know about and understand the benefits of opportunity zones, as clients will undoubtedly begin turning to their CPAs with questions as this legislation begins to receive more attention. More importantly, some of your most eligible clients might not be aware of the benefits of this legislation. Due to the time-sensitive nature of this tax incentive, you can be proactive in talking to your clients about the potential benefits of this entirely new and emerging tax advantage.
Source: accountingtoday.com Written by: G. Agarwal
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