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by The Bean Team on January 22, 2019
4.5 MIN READ
The Tax Cuts and Jobs Act introduced a host of transformative changes of varying significance, largely changing the way many businesses view and handle their taxes. Among those changes was the introduction of a new investment vehicle and economic development tool called Qualified Opportunity Funds, which uses a market-driven approach to help provide resources to low-income communities, called Opportunity Zones.
According to U.S. Treasury Secretary Steven Mnuchin, the goal of this new incentive is to “foster economic revitalization and promote sustainable economic growth, which was a major goal of the Tax Cuts and Jobs Act.”
These Opportunity Zones are designed to spur economic development by providing substantial tax benefits to investors.
Investing in Opportunity Funds provides three main tax incentives to investors:
- Deferral of capital gains
- Potential reduction of the amount of gain realized through a basis adjustment
- Potential permanent exclusion of gain on the appreciation for the interest in a Qualified Opportunity Fund
As per the IRS, an Opportunity Zone is:
… an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.
And a Qualified Opportunity Fund is:
… an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in a Qualified Opportunity Zone.
The gist? When investors put their money in Qualified Opportunity Zones through a Qualified Opportunity Fund, they can defer and reduce realized capital gains on the principal invested, and even eliminate their capital gains tax burden on returns earned through the sale of investments in Qualified Opportunity Zones.
Breaking Down the Tax Benefits
Typically, when an investor sells an appreciated asset, there’s a capital gain that triggers a tax event. The investor can minimize this tax burden substantially by reinvesting that capital gain into an Opportunity Fund within 180 days of the asset sale.
How does this minimize the tax burden? Because once the realized capital gain has been moved into an Opportunity Fund, the investor can defer paying capital gains taxes until December 31, 2026 or until they sell their Opportunity Fund investment (whichever comes first). Money that would have otherwise been used to pay taxes upfront can instead be invested and earn returns for many years, significantly increasing the earning potential of their dollars.
But wait, there’s more!
If the Qualified Opportunity Fund is held for at least five years prior to December 31, 2026, there is a 10% exclusion of the deferred gain. This means the investor reduces their deferred capital gains tax liability by 10%.
If it is held for at least seven years, there is a 15% exclusion of the deferred gain. Again, this means the investor’s tax liability on the deferred capital gains is reduced by 15%.
And if an investor holds their Opportunity Fund investment for at least 10 years, the gains earned from the investment qualify for permanent exclusion from the capital gains tax, and the investor can thereby expect to pay ZERO dollars in capital gains on any appreciation from their original Opportunity Fund investment.
When investors reinvest their capital gains into Opportunity Funds, they put themselves in a position to benefit from generous tax incentives that steadily improve the longer the investment is held, with key tax incentives available at 5, 7, and 10 years.
Let’s explore some scenarios below.
10-Year Scenario
An investor has $200 of unrealized capital gains in his stock portfolio, which he decides to invest in an Opportunity Fund in 2019.
By investing these gains in an Opportunity Fund, the investor is able to defer the tax he owes on his original $200 of capital gains until 2026. And, the basis is increased by 15%, essentially reducing his $200 of taxable capital gains to $170. The investor will therefore owe $40 in taxes on his original capital gains when the time finally comes to pay the bill (23.8% of the $170 taxable capital gains as per a federal gains tax of 20% and a net investment income tax of 3.8%).
Additionally, because the investor has held his Opportunity Fund investment for at least 10 years, he doesn’t own any capital gains on its appreciation. Assuming an annual appreciation rate of 7%, the after-tax value of the investor’s original $200 investment in 2029 is $353. The investor reaps a 5.85% effective annual return.
- Total tax bill in 2029: $40
- After-tax value of investment in 2029: $353
- Effective after-tax annual return on $200 capital gain in 2019: 85%
7-Year Scenario
As in the 10-year scenario, the investor invests $200 of capital gains into an Opportunity Fund. He holds the investment for seven years and sells the Opportunity Fund in 2026. He temporarily defers the tax owed on the original capital gains and steps-up his basis by 15%, so he will owe $40 of tax on his original capital gains in 2026.
Because the investor holds the investment for less than 10 years, he will also owe capital gains tax on the appreciation of his Opportunity Fund investment. Assuming again that his Opportunity Fund investment grows 7% annually, the investor will owe $29 of tax on the investment’s capital gain in 2026 (23.8% of $121). The after-tax value of the investor’s original $200 investment in 2026 is $252. The investor reaps a 3.36% effective annual return.
- Total tax bill in 2026: $69
- After-tax value of investment in 2026: $252
- Effective after-tax annual return on $200 capital gain in 2019: 36%
5-Year Scenario
As in the 10- and 7-year scenarios, the investor rolls over $200 of capital gains into an Opportunity Fund. He holds the investment for five years, selling in 2024. He can still temporarily defer the tax he owes on his original capital gains, but his step-up basis is only 10%, so he’ll owe $43 of tax in 2024 (23.8% of $180).
Because he holds his investment for less than 10 years, he enjoys no exemption from capital gains tax on the appreciation of his Opportunity Fund investment. Assuming an annual appreciation rate of 7%, the investor will owe $19 of tax (23.8% of $81) on the Opportunity Fund investment’s capital gain in 2024. The after-tax value of the investor’s original $200 investment in 2024 is $219. The investor reaps a 1.83% effective annual return.
- Total tax bill in 2024: $62
- After-tax value of investment in 2024: $219
- Effective after-tax annual return on $200 capital gain in 2019: 83%
Establishing a Qualified Opportunity Fund
So how does a business become a Qualified Opportunity Fund? An eligible corporation, partnership, or LLC that elects to be treated as either a partnership or corporation for tax purposes can self-certify by filing Form 8996 with its federal tax return.
If an investor realizes a gain from the sale or exchange of a capital asset to an unrelated party, he/she has 180 days from the date of disposition to reinvest the gain amount with a cash investment into a Qualified Opportunity Fund.
The Tax Cuts and Jobs Act introduced an exclusive set of capital gain tax incentives available under the newly established Opportunity Zone program. This program offers long-term investors the opportunity to earn substantially better returns than they would following a traditional investment path. To learn more about Opportunity Funds and Zones, we recommend visiting the IRS’s FAQs page, or getting in touch with the Bean Team.