Defer And Avoid Capital Gains Tax With Opportunity Zones

Dated: 01/25/2019

Views: 931

Enacted as part of the tax reform package that was signed into law in December 2017, the Opportunity Zones program is a new tool that allows individuals and corporations to take capital gain incurred from the sale or exchange of property (appreciated stocks, buildings, family businesses, and more) and roll the gain into businesses or projects located within Opportunity Zones. 

Investment in Opportunity Zones Offers Significant Tax Benefits:

  • Tax deferral on gains you invest in an Opportunity Zone (until 2026 at the latest).

  • Tax reduction (up to 15%) on gains invested into the Opportunity Zone.

  • No tax on appreciation of your investment in the Opportunity Zone if you sell your investment after 10+ years. (1)

What Is It?

A federal program that allows you to defer and possibly avoid capital gains tax by investing in a designated Opportunity Zone.

In order to capture the tax advantages of investing in an Opportunity Zone, you must form a partnership or corporation (i.e. LLC) with the specific purpose of investing in an Opportunity Zone. For purposes of this article, we will refer to this partnership or corporation as an Opportunity Entity.

You can form your own Opportunity Entity, or you can find an existing corporation or partnership in which to invest.

Who Is Eligible?

Individuals, C corporations, partnerships, S corporations, trusts, and estates are eligible to create an Opportunity Entity and invest in an Opportunity Zone to obtain gain deferral under this provision.

If a pass-through entity doesn’t choose to use this provision, or only partially defers an eligible gain, then you as a partner, shareholder, or beneficiary can elect to use the Opportunity Zone capital gains tax deferral for the eligible gain that passes through to you.

How It Works

To qualify, your gain must meet three requirements:

  • The gain must be a capital gain, either short term or long term.

  • The gain must be recognized for federal income tax purposes prior to January 1, 2027.

  • The gain isn’t from a sale or exchange with a related person.

Once you sell your original asset and recognize a capital gain, you'll have 180 days to roll the gain proceeds into the qualified Opportunity Entity.

The 180-day period starts on the day you'd normally recognize the gain for federal income tax purposes. For example, for a stock sale, the 180-day period starts on the trade date.

If your gain comes from a pass-through entity, then your 180-day period starts on the last day of the taxable year of that entity. 

You don't have to invest all the proceeds—just the amount of gain you realized on the sale, or the portion of the gain that you want to defer. The basis is yours to keep.

And you don’t have to make a one-time investment to obtain deferral. You can invest the capital gain you want to defer over time as long as each investment meets the 180-day period from your sale or exchange. 

After rolling your gain into the Opportunity Entity, you will have an additional 180 days to identify a project, close on the land, and secure financing (if any) for the project. You will then have 30 months to invest all of the money and complete the project.

Required Election

You'll need to make an election to defer the capital gain on your tax return. The election is on a per-sale or exchange basis; therefore, if you have multiple sales, each sale can qualify if you invest the capital gains from each specific sale in a qualified Opportunity Entity. (Remember, you invest the gain only—you get to keep the basis.)

Gain Deferral

The longer you hold your qualified Opportunity Zone investment, the less tax you will be required to pay.

You'll defer the gain from your original asset sale until the earlier of:

  • The date you sell your investment in the Opportunity Zone, or

  • December 31, 2026.

On the date above, your taxable gain will be

  • The lesser of your deferred gain, or the fair market value of the investment in the Opportunity Zone,

  • less your basis in the qualified Opportunity Entity

Your basis in the qualified Opportunity Entity is:

  • Zero if you hold the opportunity investment for less than five years, or

  • 10 percent of your deferred gain if you hold the opportunity investment for at least five years but less than seven years, or

  • 15 percent of your deferred gain if you hold the opportunity investment for seven or more years.

If you hold the opportunity investment beyond December 31, 2026, your new basis in the Opportunity Entity will be equal to your initial deferred gain as you will have recognized that gain as taxable income on December 31, 2026.

Again, the longer you hold your qualified opportunity investment, the more basis you'll have in it when you sell it, and the less tax you will be required to pay.

Permanent Deferral of Gain on Opportunity Zone Investment

Here’s where this provision can save you a significant amount of money. If you hold the qualified Opportunity Entity investment for at least 10 years, then your basis in it is 100 percent of its fair market value on the sale date, leaving you with zero taxable gain on the sale.

Example (Assuming a 10+ Year Investment Hold Period)

  • On December 1, 2018, you sell $8 million of stock with a cost basis of $3 million for a long-term capital gain of $5 million.

  • Within 180 days from the sale, you form a corporation or partnership designated as a qualified Opportunity Entity to invest in an Opportunity Zone.

  • You roll the $5 million gain into the qualified Opportunity Entity within the same 180 day window.

  • You make an election on your 2018 tax return to defer the $5 million in long-term capital gain income, meaning no taxes on this gain in 2018.

  • On December 31, 2026, your qualified Opportunity Entity has a basis of $750,000 (15 percent of the deferred $5 million capital gain) since you held it for at least seven years.

    • Note: If you sold your investment prior to seven years, but held it for at least five years, your basis would have been $500,000 (10 percent of the deferred $5 million capital gain) and you would have been required to pay capital gains tax on $4.5 million)

  • Back to the original example - let’s assume the opportunity investment has a fair market value of $7 million on December 31, 2026. You'll have a deemed sale on December 31, 2026, and recognize $4.25 million in income, computed as follows:

  • $5 million, which is the lesser of the deferred gain ($5 million) or the fair market value of the Opportunity Entity ($7 million), less

  • $750,000, the basis in the fund.

  • On January 1, 2027, your basis in the qualified Opportunity Entity is $5 million ($750,000 original basis plus $4.25 million of deferred gain recognized and taxed in 2026).

  • If you sell the qualified opportunity investment in August 2028 for $10 million, then your basis in the fund is $10 million and you recognize no taxable gain on the sale, since you held it for more than 10 years.

Overall, you have a total of $10 million in gains from these transactions: $5 million from 2018 and $5 million in 2028. Using the qualified Opportunity Entity investment strategy, you

  • temporarily defer $4.25 million of long-term capital gain from 2018 to 2026,

  • permanently exclude $750,000 of long-term capital gain in 2018 from taxation,

  • and have a tax free gain of $5 million in 2028.

Is it Worth It? (Opportunity Zone Investment Returns Vs Traditional Investment Returns)

Example:

On December 1, 2018, you sell an asset (condo, stock, business, etc) for $1,500,000. Your basis in the asset was $500,000, leaving you with a long term capital gain of $1,000,000.

Scenario 1:

  • Within 180 days, you create an Opportunity Entity designated to invest in an Opportunity Zone and roll your $1,000,000 gain into this entity.

  • You then invest the money into a project (rental homes, apartment complex, office building, mini storage, etc) in an Opportunity Zone.

Scenario 2:

  • You pay federal capital gain taxes on your $1,000,000 gain and invest the remainder ($800,000) into an asset that does not qualify for the Opportunity Zones program.

________________

In both of these scenarios, we will assume a 6% annual rate of return and that you are single tax filer.

The spreadsheet in the link below shows the net result under both scenarios assuming a sale of the asset at the end of the given year.

Please CLICK HERE to view the spreadsheet

________________

Opportunity Zone Compared with a Section 1031 Exchange

With an Opportunity Zone investment, you invest only the capital gain component in obtaining the deferral. With a Section 1031 exchange of real estate, you invest both your basis and the capital gain to achieve deferral.

Section 1031 exchange does not ever allow for a permanent exclusion of capital gain tax, whereas an opportunity investment will offer an exclusion for a portion of gain if held long enough.

Section 1031 exchange must originate from the sale of real estate, whereas funds invested in an Opportunity Zone can be realized from the sale of almost any asset creating a capital gain.

Additional Questions

  • What percentage of the total project cost has to be invested in improvements?

    • The amount invested in improvements must be equal to or greater than the investment in the land or existing improvements.

  • Can I obtain debt financing or outside equity investment to fund a portion of the project?

    • Yes

  • Can I sell a property that I currently own in an Opportunity Zone and purchase another property in the same zone?

    • Yes

Not All About the Taxes

The idea of avoiding taxes on your capital gains certainly has appeal, but you shouldn't let the capital gain deferral and exclusion cloud your judgment on the merits of the Opportunity Entity investment.

For this investment to work to your benefit, you need to make money on it. You should aim for a good after-tax rate of return, as you would with any investment.

Takeaways 

A qualified Opportunity Entity investment can 

  • temporarily defer your capital gains taxes (must recognize the gain no later than December 31, 2026 and pay the tax in 2027),

  • permanently delete up to 10 percent of the capital gains that would otherwise be subject to taxation if you hold the investment for more than five years but less than seven years,

  • permanently delete up to 15 percent of the capital gains that would otherwise be subject to taxation if you hold the investment for more than seven years, and

  • create non-taxable capital gains on your investment in the qualified Opportunity Entity if you hold the investment for at least ten years.

There are no tax benefits outside of deferral if you hold your investment for less than five years.

For this strategy to make great financial sense, you need 

  • your investment in the Opportunity Zone to appreciate and

  • to hold the investment for at least ten years so that the appreciation is tax-free when you sell your investment. (2)

Project Ideas (a few of many):

  • Develop rental homes on residential lots

  • Renovate existing buildings

  • New apartment development

  • New retail development

  • New office development

  • New mini storage development

Opportunity Zones in Coastal Alabama & Florida

Fortunately, some of our local areas have been designated as Opportunity Zones:

Pensacola Locations

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Mobile Locations

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North Baldwin County Locations

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South Baldwin County Locations

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Interested in selling your coastal Alabama or Florida property and investing in an Opportunity Zone near you?

Access an interactive map by clicking here

Interested in capturing the tax advantages of investing in an Opportunity Zone?

Please contact Lance Niel for more information and project opportunities.

Phone: (251) 979-9198

Email: lance@thenielgropup.com    


Lance Niel, Erin Niel, nor The Niel Group is a qualified tax accountant, CPA, attorney, or advisor. The information above may have inaccuracies especially in light of the IRS continuing to release and finalize the guidelines surrounding the Opportunity Zones program. Please consult with a trusted and qualified tax advisor before making any investment decisions regarding the Opportunity Zone.

(1) Flachsbart, A. (2019). Retrieved from http://opportunityalabama.com/

(2) Bradford Tax Institute. (January 2019). Tax Reform's New Qualified Opportunity Funds: Helpful or Hype? Retrieved from https://bradfordtaxinstitute.com/

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Lance Niel

As an Orange Beach homeowner and resident, Lance enjoys living the Gulf Coast lifestyle and is passionate about sharing it with others. He helps his valued clients achieve wealth creation and personal....

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