- Gerry Dick
O-Zone InvestingPosted: Updated:
The Tax Cuts & Jobs Act of 2017 created a new type of tax benefit that Forbes dubbed "the most unbelievable tax break ever?" It's all about investing in "Opportunity Zones" (O-Zones). Could this be opportunity knocking on your door?
A question asked by many is “why was this tax benefit created”. It is estimated that US taxpayers have trillions of dollars in unrealized capital gains or paper profits. The Opportunity Zone legislation was meant to provide investors an incentive to unlock these dollars for economic development.
Several business people, including Sean Parker, former Facebook president and developer of Napster, recognized that many investors were reluctant to sell investments that had appreciated in value due to the tax burden that resulted from the sale. Their idea was to provide a motivation for investors to realize their capital gains and reinvest in businesses or real estate projects in disadvantaged areas of the country. The Opportunity Zone legislation allows investors to defer the payment of capital gain tax and exempt capital gain on the new investment’s future appreciation.
How It Works
Governors across the country designated over 8,700 tracts of land in economically depressed areas that met the criteria as “Qualified Opportunity Zones.” Taxpayers who invest in those areas can receive up to three potential benefits:
- tax deferral of realized capital gains,
- opportunity to eliminate capital gain tax on up to 15 percent of those deferred gains, and
- no tax on the future growth in value of the O-Zone investment.
It may sound complicated, but it’s not. For example, if you have a $50,000 capital gain in a stock and you sell that stock, you’ll be subject to capital gains tax. The tax rate is based on your income and is typically at least 15 percent and may be as high as 23.8 percent.
However, if you reinvest that $50,000 capital gain into a qualified O-Zone investment within 180 days, you can defer the tax on that capital gain until you sell the O-Zone investment or December 31, 2026, whichever comes first.
If you have held the O-Zone investment for five years by year-end 2026, the taxable gain is reduced by 10 percent. If the O-Zone investment is held for seven years by year-end 2026, your gain is reduced by 15 percent. If you achieve the full 15% reduction, you pay tax on only $42,500 of your original $50,000 realized capital gain!
Holding on to the O-Zone investment for ten years or longer gives you an additional benefit. Any capital gains resulting from the appreciation of the O-Zone investment will not be taxed. So, if your $50,000 investment is worth $75,000 after ten years, all that growth is tax free!
How to Participate
It didn’t take long for investment managers to create Opportunity Zone Funds. You have several options to choose from, so you’ll need to do your due diligence before investing. Most importantly, ensure the fund manager has expertise in the type of investment being proposed for the O-Zone area.
Do remember that any investment can lose money. If your O-Zone investment fails, you still owe the tax on your 2026 tax return for the capital gain that you realized in order to make the investment, but your investment could result in a capital loss instead of a gain.
Note: To reap the tax benefits, this type of investing should be considered long-term and illiquid. Since it likely won’t be easy for a fund manager to liquidate the underlying investments, you may have restrictions on how often you can make redemptions even after your 10-year holding period.
Another option: You don’t need an investment manager to invest in an Opportunity Zone. You can create your own fund by completing IRS Form 8996 and self-certifying that it is a Qualified Opportunity Fund. But proceed with caution! The IRS has very specific criteria you must meet to have it defined as an O-Zone investment and receive the associated tax benefits. Lack of compliance could result in the loss of those benefits.
For more information on Opportunity Zones in Indiana, visit https://www.iedc.in.gov/programs/indiana-opportunity-zones/home
Do you have unrealized gains in your portfolio? While the extent of economic development that Opportunity Zone investing will generate is uncertain, the ability for investors to defer and potentially reduce capital gains as well as exempt tax on future appreciation is worth exploring. However, given the nature of this type of investing, you should seek advice from a tax attorney or knowledgeable investment advisor. This new tax benefit could be opportunity knocking on your door!
Sarah Mahaffa, CFP is a Senior Wealth Advisor with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website or email Sarah.