The new tax reform legislation, the Tax Cuts and Jobs Act, added a program called “Opportunity Zones” into the tax law. Similar to the 1031 exchange, Opportunity Zones is an economic development designed to benefit long-term investments by deferring capital gains taxes. Investors do not need to live in an Opportunity Zone to get the tax benefits, all they need to do is invest in a Qualified Opportunity Fund.
Opportunity Zone Basics
Opportunity Zone: “An economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” See IRS Notice 2018-48, Bulletin No. 2018-28, July 9, 2018 for the official list of all designated qualified Opportunity Zones; for an interactive map, click here.
Qualified Opportunity Fund: “An investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in an Opportunity Zone and that utilizes the investor’s gains from a prior investment for funding the Opportunity Fund.”
As of August 2018, an eligible taxpayer can self-certify to become a Qualified Opportunity Fund. However, there are many requirements to stay in compliance as an Opportunity Fund, including having 90% of the Fund assets invested in Opportunity Zones.
Unlike a 1031 Exchange, the investment in an Opportunity Fund only requires the capital gains portion from the sale, not the entire proceeds from the sale (basis plus gains). Reinvesting the capital gains in a Qualified Opportunity Fund will allow investors to defer the capital gains until the earlier of the date on which an investment is sold or exchange, or December 31, 2026. Investors should understand the key differences between Opportunity Zones and 1031 Exchange in order to take advantage of this investment vehicle for their next long-term investment.
Sources: Adams and Reese LLP, Asset Preservation Incorporated
Opportunity Zone Investment Tax Break
In a related Forbes' article, billionaire Sean Parker, the original Facebook president, said, “People were sitting on large capital gains with low basis and huge appreciation. There was all this money sitting on the sidelines.” The Opportunity Zones legislation is believed to be the solution to the problem by encouraging investors to “put money into places where they wouldn’t normally invest.” Forbes put together a fantastic breakdown of the numbers comparing a Conventional investment and an Opportunity Zone investment. The flow chart (see below) depicts a great example of a tax saving tool for any investor having a large amount of capital gains this year.
Source: Forbes
Opportunity Zones vs. 1031 Exchange Example
On August 1, 2018, John Doe sells an asset with a basis of $1,000,000 for $3,000,000, which generates a $2,000,000 in capital gains. John decides to invest all of the capital gains amount in a Qualified Opportunity Fund (QOF) within 180 days of the sale.
On December 31, 2026, John still owns the investment in QOF, valued at $5,000,000. John gets a 15% step up in income tax basis from $0 to $300,000 since he has held the investment in QOF for more than 7 years. He recognizes $1,700,000 in capital gains as of December 31, 2026, which further steps up his basis to $2,000,000.
On January 1, 2029, John sells his interest for $10,000,000. He elects to step up his income tax basis to $10,000,000 and recognizes no gain from the $10,000,000 sale since he has held for more than 10 years.
Any investor with capital gains he or she wants to defer should consider investing in Opportunity Zones. An advantage of Opportunity Zones over a 1031 Exchange is that contributions to the Qualified Opportunity Fund can be any type of asset or investment, agriculture included. On the other hand, investing in under-served communities with a 10-year hold presents a number of risks that need to be carefully considered by potential investors.
Qualified Opportunity Zone Funds present a promising tool for investors in agricultural projects. Many opportunity zones are located in rural areas and because farmland and timberland are generally designed to be long term investments, QOZFs are a great option for agricultural investors.
Note, everyone’s tax situation is different; therefore, investors should do their own due diligence and consult with professionals to better understand the risks involved and to determine whether an Opportunity Zone investment is the right fit for their current portfolio.