Many of you have probably heard of the Opportunity Zone program over the past few years. Created in 2017 under the Tax Cuts and Jobs Act, these federally designated U.S. census tracts offer capital gains advantages to investors as a way to encourage new businesses, housing, and jobs in areas that need development and sometimes lack access to capital.
Stock traders’ newly discovered
Opportunity Zone Funds offer a new investment option to invest short- or long-term capital gains from the sales of commonly held investments like stocks, a business, or real estate assets. If the sale produces a capital gain, the investor can place the capital gain portion into an Opportunity Zone fund.
A key feature is that stock traders, for instance, can invest their gross capital gains for the year and utilize trading losses for other tax purposes.
Assuming an investor compares an Opportunity Zone investment earning 8% annual growth per year to a non-Opportunity Zone investment also earning 8% annual growth per year, the investor may earn in tax savings approximately two times the total taxes they will eventually pay on their original capital gain. These savings are on top of investment returns that they earn, and the savings are accomplished through three distinct tax benefits offered by the Opportunity Zone program.
Opportunity Zone Program Benefits
1. Tax deferral
The capital gains tax from the original sale may be deferred through December 31, 2026, or when the investment in the Opportunity Zone Fund is sold, whichever is earlier.
2. Step-up in basis
There are also step-ups in basis if the investment is held for at least five years and at least seven years prior to the end of 2026. If the investment is held for at least five years, there is a step-up in basis of 10%. If the investment is held for at least seven years, there is a step-up in basis of another 5%. This means the investor would only pay tax on 90% or 85% of their deferred gain when filing their 2026 tax returns.
3. Elimination of capital gains tax
Additionally, if the investor holds the Opportunity Zone Fund investment for at least 10 years, any capital gain appreciation earned from the Opportunity Zone Fund investment is not taxed upon disposition. This is the most significant tax benefit provided by Opportunity Zones.
Opportunity Zone Transactions:
Let’s walk through examples involving the sales of stock, a business, and real estate. These apply, whether you sell these items personally or jointly through a partnership, S corporation, or other flow-through interest on a K-1.
Example 1: Sale of a stock
An investor bought $10,000 worth of stock in 2015. In 2020, it was worth $100,000 and they decided to sell it.
$100,000 – Proceeds from the Sale of Stock
$(10,000) – Less Basis of Stock
$90,000 – Long-Term Capital Gain
The investor keeps the original $10,000 investment in the stock, as this is a return of capital and he or she can utilize that cash as they please without paying tax. A maximum of $90,000 can be invested in a Qualified Opportunity Zone Fund, earning the tax benefits we just described.
If the investor also had $50,000 that year in trading losses from sales of other stock, those losses can be utilized to offset other gains in the investor’s portfolio, as well.
Example 2: Sale of a Business
A business sale usually produces ordinary and capital gains. The ordinary gain will come from the sale of accounts receivable, inventory and depreciable assets. The capital gain will come from the sale of non-depreciable assets and goodwill. For example, a businessperson started their business in 1990 and decided to sell it in 2020. They calculate that their basis in the company is $2.5 million and they sell the business for $6 million.
$6,000,000 – Proceeds from the Sale of Business
$(2,500,000) – Less Basis of Business
$3,500,000 – Long-Term Total Gain
This produces a $3.5 million total gain, but it needs to be allocated between ordinary and capital gains for Opportunity Zone investment purposes. It is determined that there is a $2 million ordinary gain.
$3,500,000 – Long-Term Total Gain
$(2,000,000) – Less Ordinary Gain
$1,500,000 – Long-Term Capital Gain
The businessperson can invest the $1.5 million into an Opportunity Zone Fund and defer the taxes due. He or she will then keep the $2.5 million basis and have to pay taxes on the $2 million at ordinary tax rates.
This is a critical feature of this program, as it allows the basis to be separated from the capital gain, giving the seller access to cash and not requiring the seller to keep their funds illiquid just to obtain tax benefits, as they sometimes do in charitable trusts and other tax strategies.
Example 3: Real Estate Sale
An investor purchases a rental property in 2010 for $200,000. Over the years, they invest another $50,000 in improvements before they sell the property for $500,000 in 2020. They also took $60,000 of depreciation on the building.
$500,000 – Proceeds from the Sale of Real Estate
$60,000 – Add Building Depreciation
$(250,000) – Less Basis of Real Estate
$310,000 – Long-Term Capital Gain
The $310,000 would be a Section 1231 gain, which is a type of capital gain. The investor also has a $200,000 Section 1231 loss from another property sale in 2020. The investor does not have to net the Section 1231 gains and losses together and can invest the full $310,000 Section 1231 gain into an Opportunity Zone Fund.
The key takeaway—investors only need to invest the gross capital gains for the year into an Opportunity Zone Fund—they do not have to include net capital losses.
Again, unlike a 1031 exchange, which would require this investor to roll forward their entire $500,000 investment into a new real estate project without giving the investor access to any cash, an Opportunity Zone investment allows the basis to be separated from the gain.
If you have capital gains from the sale of a pass-through interest, you can invest the capital gains realized from January 1, 2019 through December 31, 2020 on or before December 31, 2020. If you have capital gains from the sale of a non-pass through interest, you can invest the capital gains from sales that closed from October 5, 2019 through December 31, 2020, or before December 31, 2020.
Contact us to learn more about our four Opportunity Zone projects in Arizona and how you can defer and save on capital gains taxes.
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