Active investors who watch for the latest investment opportunities increase their potential to make higher profits. One of these opportunities can be found in the recently-formed tax incentive for investing in Opportunity Zones, which was initially established by the Tax Cuts and Jobs Act on December 22, 2017.
What Are Opportunity Zones?
Opportunity Zones (OZ) are rural, suburban, and urban areas identified by the government as “underdeveloped” and therefore allow you to use the profit you made from the sale of an investment (capital gain) and reinvest into business or new property developments located in OZs for a tax reduction.
The purpose of the tax incentive is to encourage investors to empower economic growth within underdeveloped communities. The first groups, or tracts, of OZs were established in June 2018 and cover parts of 18 states—including Tennessee. Currently, there are 8,700 identified OZ tracts.
How Do Opportunity Zones Work?
To invest in an Opportunity Zone, you need to invest through a Qualified Opportunity Fund that’s held by a corporation or partnership. A Qualified Opportunity Fund (QOF) is an investment vehicle that uses its investors’ capital gains from a previous investment to fund the development of Opportunity Zones properties.
How Do Opportunity Zones Benefit Investors?
If you’re an investor, you’ll find that the OZ program offers you several unique benefits, including:
- Temporary deferral on Original Gain Tax invested in a QOF—until 2026 at the latest
- 10% reduction in Original Gain Tax—if held for 5 years
- 15% reduction in Original Gain Tax—if held for 7 years
- 15% reduction in Original Gain Tax and no Capital Gains Tax on the appreciation of investment—if you cash out of the QOF after 10 years or more
Imagine you sold an investment in 2019 and wanted to use $100,000 of the capital gain to reinvest in an Opportunity Zone. To defer paying Capital Gains Tax on the $100,000, you have 180 days to roll it over into a Qualified Opportunity Fund. Let’s see what happens if you stay invested for 5, 7, or 10 years.
- 5 Years: After 5 years, you will sell your investment in 2024. The program allows you to reduce your Original Gain Tax basis by 10%. So, you only have to pay tax on $90,000 of the $100,000 Original Gain and on the appreciated amount.
- 7 Years: Instead, suppose you sell after 7 years, in 2026. The program allows you to reduce your Original Gain Tax basis by 15%. So, you only have to pay tax on $85,000 of the $100,000 Original Gain and on the appreciated amount.
- 10 Years: Now, suppose you sell after 10 years, in 2029. The program still allows you to reduce your Original Gain Tax basis by 15%. So, you only have to pay tax on $85,000 of the $100,000 Original Gain, and—because of the 10-year mark—the program allows you to exclude Capital Gains Tax on the appreciation of the Opportunity Zone investment!
Let’s See How This Plays Out In An Example
You have $100,000 of capital gains from a stock sale in 2019. Normally, you would be taxed on this immediately, leaving you with $76,200 to reinvest (assuming a 23.8% tax rate). Instead, you can invest in a Qualified Opportunity Fund with the full $100,000 gain and defer those taxes to the end of the year 2026. When you do eventually owe those taxes, you will only owe $20,230 in taxes rather than the $23,800 you would have owed in 2019.
If you held this QOF investment for 10 years, and it grew at a 7% rate annually, your investment will have grown to $196,800. This $96,800 capital gain will be completely tax-free. After all taxes on the original gain have been accounted for, you will take home $176,570. Compare that to a standard portfolio investment where (assuming all things equal) your final tally would only come to $114,424.
The Investment Breakdown: Qualified Opportunity Fund Vs. A Standard Portfolio Investment
Ready to Increase Your Investment Opportunities Zones?
If you want to take advantage of Opportunity Zones, we’d be happy to provide you with more information or a free consultation that will help you get started with investing in a Qualified Opportunity Fund. Connect with our investment professionals today!
We are also very excited about discussing Opportunity Zones and Opportunity Funds with the greater Nashville community. Please reach out to us if you have a group that would benefit from learning about Opportunity Zones.