Opportunity Zones are a tax incentive created by the Tax Cuts and Jobs Act otherwise known as the Trump tax law. These incentives are meant to provide an avenue for the taxpayer to defer capital gain income while encouraging investment in economically depressed areas. If the taxpayer jumps through the necessary hoops significant tax savings is possible.
Great! Now how do I go about reducing my tax bill?
First, within 180 days of the sale that generated the capital gain, the capital gain is plowed into a qualified opportunity fund. There are companies out there that administer qualified opportunity funds and ensure the necessary requirements are met. The qualified opportunity fund will then invest in one of the qualified Opportunity Zones.
Kansas Opportunity Zones can be found here: https://www.kansascommerce.gov/programs-services/federal-opportunity-zones/opportunity-zones-map/. The Missouri Opportunity Zones are found here: https://ded.mo.gov/content/opportunity-zones. When looking at both maps you will see urban and rural areas that are qualified Opportunity Zones. There are more than 8,700 designated Opportunity Zones across the country.
The law spurs taxpayers to leave the investment in the qualified opportunity fund. The longer the investment is left in the fund, the more tax the taxpayer is able to avoid. When the deferred capital gain is contributed to the qualified opportunity fund there is no basis in that initial investment. Basis is what’s deducted from the selling price to determine the capital gain. So the basis is zip, zero, nada up to the 5 year mark.
Example 1 – Patrick sells his PayPal stock for a gain of $10,000 on July 2, 2018. He then turns around on October 5, 2018 and invests the $10,000 into a qualified opportunity fund. He decides to exit and sell his investment in the qualified opportunity fund on February 5, 2023 for $18,000. Remember, if the investment in the fund has been held less than 5 years the basis is zero. So, his gain would be $18,000.
Once the investment has been in the qualified opportunity fund for 5 years the taxpayer is eligible to exclude 10% of the original gain from tax. After another 2 years another 5% of the original gain escapes tax.
Example 2 – Same scenario as Example 1. Instead, Patrick sells his investment in the qualified opportunity fund on December 20th, 2026 for $18,000. After 7 years Patrick is able to use 15% of his original investment as basis. His original investment/gain was $10,000 so $1,500 would be his basis. So his total gain would be $16,500 ($18,000 less $1,500 basis).
Finally, after another 3 years, which is 10 years total, the taxpayer may sell their investment in the qualified opportunity fund and the sales proceeds are 100% tax free.
Example 3 – Same scenario as Example 1. Now, Patrick sells his investment in the qualified opportunity fund on August 5, 2028 for $18,000, meeting the 10 year holding requirement. The $18,000 sale proceeds will result in $0 tax.
As you can see keeping the investment in the qualified opportunity fund for at least 7 years but not quite 10 years only gets you a relatively small tax savings when waiting until 10 years gets you the full 100% tax savings.
It’s clear that the tax code wants the taxpayer to keep the investment in the fund for at least 10 years. This keeps investment in those distressed areas and as a carrot, gives the taxpayer an exclusion from tax when their interest in the qualified opportunity fund is sold.
The Opportunity Zone incentive hasn’t received a lot of attention. As shown in the examples above there is tremendous opportunity available to avoid capital gains tax while increasing investment in the desired Opportunity Zone areas. Contact me if you have any questions.