Picture yourself holding $100,000 in capital gains from the recent sale of an asset. You realize if you don’t do any tax planning, you’ll be forced to pay $20,000 or more in taxes. So, you meet with your tax adviser, and then decide to put your money in a new tax-deferred fund that offers considerable long-term savings.
Fast-forward a decade. You paid the deferred taxes on the original $100,000 capital gains two years ago, and you’re ready to close the account. As it turns out, the fund performed well and your investment is now worth $200,000. Suddenly, you envision being hit with a tax bill for the additional $100,000 profit.
Or will you?
In this hypothetical scenario, the answer is no. That’s because the reinvestment vehicle you chose was linked to an “opportunity zone,” an economically distressed community where new investments are eligible for preferential tax treatment thanks to a little-known, until recently, provision buried within the Tax Cuts and Jobs Act of 2017.
Written into the bill by South Carolina’s own Republican Sen. Tim Scott, opportunity zones are a federal incentive designed to stimulate economic growth in designated regions by allowing investors to defer taxes on capital gains income until 2026, provided 90 percent of their investment stays in low-income communities via properties or businesses. The law goes on to reduce capital gains exposure from the original sale by 10 percent for investors who remain in the investment for five years, and 15 percent for those who stay invested seven years. Additionally, after 10 years in an opportunity fund, investors can permanently forgo paying capital gains taxes on the sale or exchange of their opportunity zone investment.
While the opportunity zone provision went relatively unnoticed the first half of 2018, it’s begun to generate considerable buzz in the mainstream media, as pundits publicly debate the virtues and vices of the legislation. Proponents praise the rule as a way for the private sector to pump trillions of dollars into impoverished areas nationwide, helping to preserve or expand affordable-housing options while spurring revitalization through equity investments in small businesses and real estate projects. In South Carolina alone, 128 low-income community tracts stand to benefit from the program.
Opponents, on the other hand, argue that opportunity zones will only accelerate gentrification, driving up housing costs and pushing out longtime residents. They also fear that capital from opportunity funds could be used for projects that do little, if anything, to support affordable housing, create jobs, or fund new businesses.
Opinions may differ on the amount of economic growth opportunity zones will ultimately generate, but once the Treasury Department issues specific guidelines on how the program will operate and what rules investment funds must follow — both of which are expected later this year — one thing seems certain: Investments should start happening quickly. Real estate developers, in particular, are poised to take advantage of the program, and in time, retailers and hoteliers will likely utilize the provision to expand their bricks-and-mortar footprints in select areas. For individuals who own property in designated opportunity zones, the future is equally bright, as land will be in high demand.
Before deciding to invest in an opportunity fund, you’d be well-served to consult a seasoned tax adviser, ideally one who has considerable experience and relationships within the real estate sector. He or she can explain the nuances of the program, conduct financial modeling to show the after-tax impact of investing in an opportunity fund, and help you determine whether the strategy makes sense for your particular situation. Should you choose to invest, your adviser can help structure the deal to leverage all available incentives, and then provide ongoing guidance to ensure you remain in compliance with all regulations.
As with any investment, there’s no guarantee opportunity funds will yield the types of returns realized in the fabricated storyline described above. However, should you seize the proverbial opportunity of opportunity zones, you’ll most certainly enjoy considerable tax benefits as well as the satisfaction of knowing your money is being used for a greater good.
If you have more questions related to opportunity zones and how to take advantage of them, please reach out your Elliott Davis tax advisor.