In an effort to spur economic development a program called Opportunity Zones were created under the 2017 Tax Cuts and Jobs Act. The goal is to attract long-term investments by giving tax incentives to those will re-invest their unrealized capital gains in a Qualified Opportunity Fund (QOF).
A QOF is essentially an LLC that is dedicated towards investments in Opportunity Zone assets – real estate, businesses or business assets; and there are over 900 zones across California!
- Instead of paying your capital gains tax you can re-invest those proceeds in a QOF and defer your payment of that tax until 2026.
- The QOF needs to substantially improve the investment it acquires.
- The gain on sale of the QOF investment can be completely tax free after 10-years.
Key People this Opportunity is for:
- Those who have blown their 1031 exchange
- Those selling appreciated stock and want to invest in real estate
- Sellers of a business – they can re-invest their gain in another business or real estate, or certain publicly traded opportunity zone funds.
- Property owners in the opportunity zone looking for an investor to buy and improve the property.
For your investment to be qualified in the Opportunity Zone, it must be:
- Made via a Qualified Opportunity Fund. The fund must hold at least 90 percent of its assets in Opportunity Zones.
Derived from a gain in another investment.The gain is transferred into an Opportunity Fund within 180 days of realizing the
A business can be qualified as an Opportunity Zone business if:
- Substantially all the tangible property owned or leased is used in an opportunity zone
- At least 50% of the gross income earned by the business is coming from the active conduct of business within an Opportunity Zone.
Note: Not all rental real estate is an active trade or business.
In addition to the above criteria, certain businesses are excluded from the program. They can't be a “private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.”
Notably, residential development is not included as a prohibited business, so a qualifying business is not limited to commercial developments.
Once the investors' capital gains are invested to QOFs, these investors will receive the following tax incentives:
- Deferral of taxes on capital gains. Investors pay no tax until the end of 2026 or when the asset is disposed of, whichever is earlier.
- Step-up in basis.The basis is increased by 10 percent if the investment is held for at least 5 years and by an additional 5 percent if held for at least 7 years, thereby excluding up to 15 percent of the original deferred gain from taxation.
- Elimination of tax on new gains.Investors pay no taxes on any capital gains produced for investments held for at least 10 years.
Note: California has not conformed to the Federal change in the tax law. The capital gains tax savings will be equivalent to the federal capital gains tax you would have otherwise owed.
Example of Potential Tax Benefits from Investing in Opportunity Zones
Bob and Jane sell the business that they started and ran for 30-years for $600,000. Their accountant determines that they will have a $500,000 capital gain, which at the federal rate (20%) means they must write a check to the IRS for $100,000. Instead of paying the IRS now, Bob and Jane put that $500,000 or some portion of it, into a Qualified Opportunity Fund (QOF). That QOF buys a duplex in an Opportunity Zone and converts it into a 4-plex. Bob and Jane will have to pay $85,000 in capital gains tax on their 2026 tax return for the underlying gain that they reinvested into the QOF. The big benefit is that if Bob and Jane hold their 4-plex for 10-years before selling it – they will pay no tax on the gain from the sale of their 4-plex.*
*Assuming they also meet all the technicalities of the law – this is general advice for illustration purposes and not to be taken as legal advice for your specific situation. Consult your own attorney for your personal situation!