What Are Qualified Opportunity Zones and Their Significant Tax Incentives?

Daniel Penzing
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Opportunity Zone Tax Benefits

And How They can Benefit you:

The Tax Cuts and Jobs Act of 2017 is one of the most significant corporate and individual tax overhauls since the Reagan administration of 1986. As a result, many of the tax incentives, deductions and benefits have been greatly altered or completely eliminated. Opportunity Zones (OZ) are one of the few exceptions. OZs are tax-advantaged designated zones that are spread throughout areas of the country that are considered to be Economic Opportunity Zones that have been inoperable. Both foreign and domestic investors can participate in the OZ program and take advantage of their significant tax benefits.

Qualified Opportunity Zones have a total capital gains and dividend tax exemption. That means if you participated in a qualified investment in an OZ you would be exempt from capital gains and dividend taxes. OZ investments are also 100% exempt from capital gains and dividend taxes for any deferred capital gains if you hold your investment for five years per Section 1400Z-2 of the Internal Revenue Code.

Furthermore, any capital gains contribution will not reduce capital losses. Furthermore, the capital losses are not subtracted from capital gains and are not considered to be short term capital gains when calculating long term capital gains. The United States government calls the Opportunity Zone tax benefits an aid program for distressed communities.

Why This Legislation and Why Now?

In recent years, there has been considerable attention paid to the massive amount of wealth that is managed and controlled by institutional investors such as mutual funds, foundations, and pension plans.

A review of the numbers shows that these institutional investors are managing significant portions of the portfolios and from this, incomes flows, tax-free, directly to charitable and other philanthropic institutions to the tune of many hundreds of billions of dollars the past few years.

With the inclusion of the QOZ options, the legislation gives these same institutional investors more flexible options, by providing substantial tax cuts to non-profits that then might put this money back to charitable works and community projects that are assisting large numbers of Americans in urban inner cities, remote trailer parks, and every region in between.

This is a wise use of the tax code, by identifying those funds that currently can be directed to social benefits in ways that make actual sense and then using the tax code to make this transfer of assets more efficient and more in line with the objectives of many investors.

How to Take Advantage of This Program With a Qualified Opportunity Fund

It seemed in January 2018 that the top people at the Treasury had their sights set on a comprehensive tax reform plan and they were ready to build a good case for it. The primary focus of the pitch was that the way to a better U.S. economy was to simplify the tax code and cut rates across the board.

At the time, we applauded the effort and reminded you of the potential windfall of additional after-tax cash. At this time, when the stock markets have been going through a volatile time and a lot of people are wondering whether they should get back into stocks or hedge their investments, wealth creation is once again on everyone’s mind.

Currently, the United States individual tax code has seven brackets: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. Under the prior ruling of Tax Cuts and Jobs Act, there will be only four tax brackets: 12%, 25%, 35%, and 39.6%.

The Benefits of Short-Term Opportunity Zone Investing

Visually, Opportunity Zones are pretty similar to other real estate investment trusts (REITs). They’re issued by non-traded REITs, rather than traded on the stock market. And in recent years, they’ve become one of the most popular ways investors have made money in the bull market. But what are REITs, exactly?

REITs, in general, are real estate investment trusts. They’re a type of fund that holds reinvested gains, similar to bond funds or investment trusts.

These funds are developed by real estate investors who sell properties to raise capital for more properties. Investors purchase shares in these REITs in the same way they’d purchase stocks in a public company.

While investors used to seek out companies with a fantastic property portfolio and a well-functioning management team, all they have to do with REITs is buy into a company that has a fund comprised of diverse properties.

And that’s why REITs have grown in popularity. For investors interested in diverse, low-risk, investment opportunities, they’re the perfect way to grow the value of a portfolio gradually and continue making money over the long term.

A Sample Calculation of Capital Gains Tax on Accrued Earnings of a QOF Investment Held for 10 Years

The earning potential of QOF investments is unquestionably exciting and enticing for investors in the platform, but what happens when the possibility becomes a reality? What happens when the operator of an Opportunity Zone earns significant profits that they might want to realize using a sale, as opposed to continuing or expanding the project? Well, it depends.

The tax treatment of QOF is determined by whether the time frame for the realization of significant profits can be deemed “long” or “short”. If the time period is deemed “long”, then the original QOF earn back rule would apply in full: Earnings are free of tax, and the investor can realize them at any time after 5 years without being responsible for capital gains tax. “Long” also looks like “long” within the context of the life of the overall project, so if it has existed for 5 years at the time of the sale, there’ll be no tax at all.

In the case that the time frame is deemed to be “short”, then the tax treatment shifts towards more conventional Real Estate expectations. Basically, the earnings owed become capital gains, and will be subject to capital gains tax at the investor’s marginal rate as determined for their tax bracket, plus a 3.8% investment by investors or 8% upon significant profits from QOF investors.

An Easy Way to Invest in Qualified Opportunity Zones

Qualified Opportunity Zones are designated areas of high poverty (25% or greater), low population density (less than 1,500 per square mile) and low per capita income (85% below the national average).

The new Tax Cuts and Jobs Act has made it easier for investors to invest in Qualified Opportunity Zones. If an investor invests in Qualified Opportunity Zone assets, currently the investor is entitled to two things:

Partial Expensing for Qualified Opportunity Zone Investments

You may deduct 15% of the taxable income from the economic activity earned directly (or indirectly) from the Qualified Opportunity Zone investment. If you are individual, the partial expensing deduction is applied against your itemized deductions, and if you are a corporation, you can take the expensing deduction against the Current Tax Income.

Earnings from Qualified Opportunity Zone Investments is Deferred until Expiration of the 10-year Holding Period

Any gain you realize on the sale of assets held within a Qualified Opportunity Zone is deferred if the gain is reinvested into the Qualified Opportunity Zone within 180 days. If the gain is reinvested into the same Qualified Opportunity Zone, the deferred gain is eligible for the capital gain rate of 20%. However, if the gain is reinvested into a different Qualified Opportunity Zone, the deferred gain is subject to capital gains tax at the investor’s ordinary income tax rate.

The Big Money Is Chomping at the Bit for Opportunity Zone Investing