According to the IRS: “An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.” Opportunity zones were authorized by the Tax Cuts and Jobs Act in 2017. Over 8,700 opportunity zones were identified last year. The hope is that new investment will jump start economic growth, distributing prosperity more broadly throughout the country. IRS Regulations on these zones were issued in October 2018 and April 2019. For a list of these zones in Kansas, you may visit the Kansas Department of Commerce website.
There are two distinct tax breaks: tax deferral and tax forgiveness.
When an investor has a substantial capital gain, the gain may be rolled over to an investment in an opportunity fund. The new investment must be made within 180 days, but all gains harvested during that period may be rolled together. With the rollover, the tax on the capital gain may be deferred until December 31, 2026. That means the entire amount of the gain is available for reinvestment, not just the after-tax proceeds.
If the new investment is sold early, the deferral of tax ends and the capital gain tax must be paid. However, if the investment is held for at least five years, the basis is increased by 10%, and if it is held for seven years, the basis is increased by 15%. However, only investments made this year will reach the seven-year mark before the December 31, 2026, expiration of the deferral period.
If the taxpayer holds his opportunity zone investment for ten years or more, there will be no tax at all on any capital gain.
Opportunity in action
Irene sells stock worth $1.4 million that has a tax basis of $400,000, realizing a long-term capital gain of $1 million. She will owe federal taxes of $238,000 on the gain, including the Medicare taxes on net investment income. That means Irene will have $762,000 left for a new investment. Gains on the new investment also will be fully taxable.
Irene chooses instead to invest the entire $1 million in an opportunity zone fund. She won’t have to pay the $238,000 until she sells the new investment. If she holds the new investment for five years, the tax falls to $214,200. If she makes the investment this year and holds it until the end of 2026, the tax falls to $202,300. That’s when the deferral period ends, and she will have to pay the deferred capital gain tax with her 2026 tax return in the spring of 2027.
Meanwhile, the investment in the opportunity fund has its own performance record. Assuming average growth of 7.2% annually, the investment will be worth $2 million after ten years. Should she sell it then or thereafter, there will be no tax on the capital gain, a potential tax savings of an additional $238,000.
Of course, there is no guarantee that an investment in an opportunity zone fund will pay off. The point of providing the tax subsidy is to offset the perceived risks associated with investments in the distressed zones. Those risks don’t disappear just because a tax benefit is made available.
At The Trust Company of Kansas, we help people. We promise to minimize the burden of wealth management and bestow the freedom to enjoy everything else. The officers at The Trust Company of Kansas are always willing to discuss your financial goals with you and help you to create a plan that is well-aligned with your wishes. If you have a specific question about investment planning, please contact us at (800) 530-5254 or visit tckansas.com/contactus, and one of our Certified Trust and Financial Advisors will be happy to assist you.