On December 22, 2017, a new piece of tax legislation was signed into law to amend the Internal Revenue Code of 1986. The Tax Cuts and Jobs Act of 2017 created Opportunity Zones to encourage long-term private sector business and real estate investments in qualified communities all over the U.S. Locations in developing urban and rural communities are nominated for designation as qualified Opportunity Zones by state governors and certified by the Secretary of the U.S. Treasury acting through the IRS.
A list of Qualified Opportunity Zones can be found on the Department of Treasury website.
How it Works
Investors in the U.S. currently hold $1.6 trillion in unrealized capital gains. This represents a significant resource with untapped potential for economic development. Investors with capital gains tax liabilities throughout the U.S. will find the program provides the potential for significant tax savings when investing in certified Opportunity Funds. The Opportunity Funds turn around and use the reallocated capital gains to make equity investments in business and real estate in qualified Opportunity Zone property.
What are Opportunity Funds?
Investments must be made in a Qualified Opportunity Fund, certified by the U.S. Treasury Department, for investors to take advantage of the capital gains tax benefits. The qualified funds must be formed as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property. At least 90% of their assets must be held in Qualified Opportunity Zone Property, which includes newly issued stock, partnership interests, or business property in a Qualified Opportunity Zone business.
Opportunity Fund investments are limited to equity investments in businesses, real estate, and business assets that are located in a Qualified Opportunity Zone. Opportunity Fund investments in real estate are also subject to a substantial improvement requirement, which requires improvements equal to the Opportunity Zone Fund’s initial investment into the existing property over a 30-month period.
The price of the land, however, can be excluded from the cost of the initial investment. For instance, if an Opportunity Zone Fund acquires existing real estate property in an Opportunity Zone for $1.2 million with the land constituting $300,000 of the price. Under this scenario, the Fund has 30 months to invest an additional $900 thousand for improvements to that property in order to qualify for this program.
Golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, race tracks or other facilities used for gambling, or liquor stores are all exclusions from the substantial improvement requirement in a Qualified Opportunity Zone.
What is Considered a Qualified Property?
One of the following following requirements must be satisfied in order for a Qualified Opportunity Zone Property to be held by a Qualified Opportunity Fund. The Qualified Opportunity Zone Property must carry on with its original intent with the Opportunity Zone Fund, meaning the Qualified Opportunity Zone Fund started the business or developed the property. If not, the Qualified Opportunity Zone Fund must substantially improve the property based on the definition of substantial improvement given above.
Investor Incentives
The Opportunity Zone program is designed to stimulate long-term investments. The longer an investor leaves their capital in the Opportunity Fund, the greater the tax savings once the interest in the Opportunity Fund is cashed out.
If the investment period is fewer than 5 years, the tax benefit is deferred payment of existing capital gains until the date that the Opportunity Fund investment is sold or exchanged. With an investment length of 5-7 years, the tax benefits are the same, plus 10% of tax on existing capital gain is canceled. When the investment length is 7-10 years, tax benefits include deferred payment of existing capital gains until December 31, 2026, or the date that the Opportunity Fund investment is sold or exchanged (whichever comes first), and 15% of tax on existing capital gain is canceled.
The biggest tax benefit comes with an investment of greater than 10 years. This 10+ year investment period includes the same benefits of a 7–10 year investment, plus investors pay no capital gains tax on the Opportunity Fund investment, meaning investments are exempt from any capital gains beyond those which were previously deferred.
Conclusion
There are many tax advantages to investing in real estate, especially for passive investors. Opportunity Funds allow investors to enjoy the benefits of professionally managed funds through long-term investment. If you already have existing capital gains, it’s important to consider the benefits of a Qualified Opportunity Zone Property, including pipeline development projects. At Pantheon Investments we can help build your real estate portfolio to maximize your investment opportunities.
