New “Opportunity” to Invest Tax Free Through Opportunity Zones

Opportunity Zone

Anytime you can invest in areas that need it the most while keeping the government’s hands off of your money in the process, count me in!

I’ve shared other strategies in the past around limiting or eliminating taxes on your investment gains, but this newer strategy is particularly interesting to me.

It’s called Opportunity Zone investing.

Congress rolled out the qualified opportunity zone (QOZ) program just over a year ago as a way to drive investment into specific areas where the median income is a lower threshold than the surrounding area, and poverty rate is above 20%.

The IRS has issued several rounds of guidance and is still working to finalize all of the rules relating to the program, but the two overarching big benefit to investors are:

Current Capital Gains Deferral/Savings

If an investor is selling an investment in an asset like stocks, business ownership, or real estate, they can roll any capital gains from the sale into an investment in an opportunity zone for a deferral for up to seven years and a 15% reduction in said capital gains.

Future Capital Gains

In my opinion this is where the incredible value lies.  If invested in the opportunity zone for at least 10 years, all new capital gains accumulated on the investment are totally tax free.

As a value add rental investor who is forcing appreciation through capital improvements, this could be a massive tax savings if handled properly.

This might not seem like a big deal on one property, but if you are a value add investor sitting on a lot of equity, or if you are just starting out and want to build a portfolio of properties with lots of equity through a value add strategy (rehabbing), the difference in the money you get to keep at the end of the 10 year period could be tremendous.

There are several nuances to this this program, like the rule that QOZ investments must be substantially improved, or that the investment has to go through an entity that is self-certified with the IRS as a Qualified Opportunity Zone.

In order to make sure you invest correctly, it is worth reading through the IRS rules and visiting, which is the non-profit organization that drove the creation of this program.

Over the last year, the IRS has taken the feedback of stakeholders who might be impacted by, or interested in QOZ’s, from investors to politicians to business owners, and is set to release it’s next round of guidance any day now, which hopefully clarifies some of the details investors have been waiting on.

Some of the top questions I am really eager to learn are:

1. Buying and Selling within the QOZ

Can an investor buy and sell assets within an Opportunity Zone throughout the 10 year period, rolling the capital gains from each asset sale into the next, with the total capital gains accumulated being excluded from tax at the end of the minimum 10 year period.

In other words, it is not clear yet if the IRS will require the same asset to be held in an QOZ for 10 years or whether you could essentially buy, rehab, and stabilize an investment in a QOZ and then sell it for a different QOZ asset and role the capital gains into the next investment without losing the tax benefit.

If the IRS allows this, it could make a major difference in the total capital gains at the end of the 10 year period that is accumulated tax free.

2. Is re-invested cash flow tax free as well?

Could I invest the cash flow from investments in a QOZ, directly back into a QOZ fund, using those funds to essentially create more capital gains either through the purchase of new QOZ assets or improvement to existing QOZ assets.

In other words, if you own a high cash flowing Opportunity Zone asset (which would be common in QOZ’s since they are typically more distressed markets), could you take that cash flow and reinvest those funds back into investments in the opportunity zone without having to realize the income and pay taxes on it.

If the IRS rules favorably on some of these yet to be determined questions, it could make a world of difference in the amount of capital gains that are excluded from tax when these opportunity zone investments are ultimately sold.

It’s also advisable to set up the structure through an attorney and CPA who has read up on the rules.  There aren’t any attorneys with years of experience working on opportunity zones because this is such a new program, but there are attorneys who have dealt with similar place-based IRS incentives in the past, and have taken a strong interest in educating themselves on the guidelines for QOZ’s.

Most QOZ funds are large multi-million dollar funds targeting large commercial projects, but let’s take a look at a few simplified possible scenarios depending on what the IRS rules in their next set of guidance:

Without Opportunity Zone

-You sell an asset for $100k capital gain

-Pay $15k in taxes

-Invest remaining $85k down payment (25%) into a $340,000 investment

-Put $150,000 into improvements

-Collect $24k/year cash flow over 10 years, which is taxed at regular income rate (minus mortgage interest deduction and depreciation)

-Sell for $1,000,000 after 10 years

-Capital Gains is $510,000

-Depreciation recaptures is around $100,000

-Total taxable amount is $610,000 at 15% is $91,500

With QOZ if IRS rules that you can’t roll capital gains in and out of properties within QOZ’s, and if you can’t reinvest cash flow into more QOZ investments

-You sell an asset for $100k capital gain

-Pay $0 in capital gain tax initially

-Invest full $100k as down payment (25%) into $400k investment

-Put $150,000 into improvements

-After 7 years 15% of original capital gains are forgiven and remainder is taxed at 15% ($12,500 due in year 7)

-Collect $28k/year cash flow over 10 years which is taxed at regular income rate (minus mortgage interest deduction and depreciation)

-Sell for $1.1mm after 10 years

-Total capital gains excluded from taxes on investment $550,000 plus approximately $120k in depreciation is $100,500 at 15% capital gains rate

With QOZ if you can roll capital gains from one property to another within a QOZ

-You sell an asset for $100k capital gain

-Pay $0 in capital gain tax inititally

-Invest full $100k as down payment (25%) into $400k investment

-Put $150,000 into improvements

-Sell the property after 2 years for $700,000 creating $150,000 of capital gains

-Invest $250,000 (original capital gain amount and new capital gain amount) as down payment (25%) into $1,000,000 asset

-Put $400,000 into improvements

-Sell the property after 2 years for $1,900,000 creating an additional $500,000 in capital gains

-Invest $750,000 (original capital gain amount and new capital gain amount) as down payment (25%) on a $3,000,000 asset

-If you repeat this process 5 times over a 10 year period, each time using your accumulated capital gains as a down payment for the purchase of larger assets, you could have over $2,000,000 in capital gains at the end of the 10 year period that would be excluded from tax.

This is the same concept behind deferring capital gains through the use of a 1031 exchange, but the big difference is after a 10 year holding period in a QOZ, the capital gains are totally forgiven, as opposed to just being deferred forever in a 1031 exchange.

This program will drive a significant amount of new investment into areas that need it the most, and at the same time, could be a great benefit to investors as well.

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