Rolled into the TCJA (Tax Cuts and Jobs Act of 2017) is an intricate set of provisions establishing a massive set of tax breaks benefitting companies and individuals with capital gains. The provisions are nestled under the heading of Opportunity Zones (O-Zones).
Opportunity Zones are underserved and undercapitalized geographic zones, numbering 8,700 in total, in which Federal and State governments wish to encourage private investment. In this case, encouragement comes in the form of capital gain-focused tax incentives. A taxpayer with nearly any variety of capital gain is permitted to invest an amount equivalent to her total gain into a Qualified Opportunity Fund (QOF), thereby deferring the recognition of this gain for up to 7 years.
A QOF is an investment vehicle which receives capital from one or more taxpayers and invests that capital into one or more qualified assets. Qualified assets generally consist of equity interests in Qualified O-Zone Businesses and equity interests in Qualified O-Zone Property (real estate or other tangible property). The flexible structure of QOFs allows significant customization to meet the widely varying needs and goals of individual taxpayers. A QOF may consist of one investor or many investors, invest in a single asset or multiple assets, and be administered or professionally managed.
Taxpayers who choose to invest in one or more QOFs rather than paying tax have three distinct tax advantages at their disposal – a deferral, a discount, and an exclusion.
The Deferral – a taxpayer with a realized capital gain has 180 days to invest the amount of that gain in a QOF. Doing so allows a taxpayer to defer recognizing that gain until 2026, so long as she holds onto her investment in the QOF. Note that only the investment in the QOF needs to be held, not the QOF's investment in any underlying assets. This differentiation allows a QOF's investments to be bought and sold without affecting the holding period, so long as the ownership interest in the QOF itself is unaffected.
The Discount – a taxpayer who takes advantage of the deferral and holds onto her QOF investment for 5 years will enjoy a 10% discount on the originally deferred gain. Hold on for 7 years and that discount jumps to 15%.
The Exclusion – by far the most powerful tax advantage of the three, the exclusion applies to any gains a taxpayer realizes from the appreciation of her QOF investment. A taxpayer who defers a capital gain by investing in a QOF and then holds onto her QOF interest for a period of 10 years will pay zero tax on any capital gains from the appreciation of that investment. Let’s assume an initial investment of $200,000 is worth $800,000 in 10 years when the taxpayer sells her interest in the QOF. Assuming the entire gain is capital, that taxpayer wouldn’t pay any tax on the $600,000 gain. The wealth and legacy-building potential of the Opportunity Zone program is unmatched by any tax break in our lifetime.
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