In 2017, Congress passed the Tax Cuts and Jobs Act which dramatically changed the tax laws in the United States. Now that you’ve survived your first tax season (and hopefully adjusted your withholdings if you got a huge refund or owed a ton of money), it’s time to pay attention to one of the somewhat overlooked aspects of the act . . . Opportunity Zones.
Opportunity Zones offer certain tax advantages to investors who opt to invest in them. Should you pay attention to these zones, and should you invest in Opportunity Zone funds? We’ll explain how they work.
What Is an Opportunity Zone?
Opportunity Zones are economically disadvantaged areas in the United States. The Tax Cuts and Jobs Act provides incentives for people who already have wealth to invest in these areas as opposed to other investment opportunities.
By providing these tax incentives, the Federal government hopes to promote economic development and revitalization in these economically depressed zones. The complete list of the Opportunity Zones is available here.
Why Should I Consider Investing in an Opportunity Zone?
Investing in an Opportunity Zone could provide you with some incredible tax incentives that make the prospect of Opportunity Zone investing very attractive.
There are three “flavors” that the tax incentives come in:
- Capital gains deferral
- Reduction in capital gains owed
- Tax-free future profits
Understanding the Capital Gains Deferral
If you invest profits (capital gains) into qualified tangible property in an Opportunity Zone, you can put off paying taxes on your capital gains until December 31st, 2026.
What does that mean in plain English?
If you’ve earned profits from selling stocks, a house (other than your primary residence), or a business, you generally have to pay capital gains taxes on your profits.
Long-term capital gains are taxed at a 15% rate for most earners (those earning less than $38,600 and $425,800 as a single person and $77,200 to $479,000 for those married filing jointly). So if you’ve earned $100,000 from selling a business, you’ll probably owe $15,000 in long-term capital gains taxes. Those taxes typically need to be paid by April 15th of the next tax year, and even then you may owe some penalty interest.
But if you choose to invest your profits in a Qualified Opportunity Zone investment (such as an apartment building in the Opportunity Zone), and you complete your investment within 180 days of earning the profit, you can put off paying taxes on your profits until December 31st, 2026.
That $15,000 you owe today? You can put off paying that for another seven years from the time of this writing. Meanwhile, your money will be hard at work in an Opportunity Zone. You don’t have to pay taxes on the gains until you sell the Opportunity Zone investment or December 31st, 2026.
Remember: To qualify you must invest your capital gains in the Opportunity Zone within 180 days of selling your investment, or you will not qualify for this benefit.
Understanding the Reduction in Capital Gains Owed
Another huge benefit of the Opportunity Zone legislation is that it gives investors the opportunity to receive a reduction in capital gains owed. After five years of investing in an Opportunity Zone, any reinvested profits (see above) experience a 10% increase in basis. Add another two years (making it a total of seven years) and you’ll see another 5% increase in basis.
What does that mean for you?
Take the example of investing $100,000 of profits from the sale of the business. If you keep that investment in an Opportunity Zone investment for five years, the IRS gives you a tax break. Instead of owing capital gains on the full $100,000, you only owe on $90,000. That means the $15,000 you owed now becomes $13,500.
Wait another two years (to the seven-year mark), and you get another 5% discount on the amount you owe. That means the IRS sees the $100,000 you originally invested as $85,000, and you only owe $12,750 when you sell your Qualified Opportunity Zone investment or on December 31st, 2026.
But investor, beware! This benefit is only available to people who complete the five- or seven-year window by December 31st, 2026. That means you have just a few months from this writing to benefit from the full 15% reduction in taxes owed. You have just two and a half years (until December 31st, 2021) to benefit from the 10% reduction in taxes owed.
While you’ll still benefit from the capital gains deferral until December 31st, 2026, the window to qualify for this incentive is nearly out the window.
Understanding Investing Without Capital Gains
The first two benefits are really for people who are already rich and want to avoid paying taxes for a while (and reduce their taxable liability). However, this third benefit is the only benefit that’s for everyone.
If you keep your investment in a Qualified Opportunity Zone for 10 years, then any profits you earn are untaxed. The key to realizing this benefit is investing in a Qualified Opportunity Zone and holding onto the investment for at least 10 years.
This benefit is not set to expire on December 31st, 2026, so it has the most long-term potential.
Is Qualified Opportunity Zone Investing for Me?
Before you consider investing in a Qualified Opportunity Zone, it generally makes sense to hit the max in every single tax-advantaged account (especially retirement accounts) before looking to the Opportunity Zone. That means making out a 401(k) with $19,500 (plus an employer match), a Roth IRA with $6,000, an HSA (if you’re eligible) with $3,550 as an individual or $7,100 as a family, and possibly even a SEP-IRA if you’re a side hustler (up to 20% of your side hustle earnings up to $58,000).
There would, however, be two exceptions to this rule. First, if you’re already planning to invest in an Opportunity Zone (perhaps you’re a rental property investor), go ahead. Keep in mind the 10-year horizon, and consider holding your investment at least a decade to enjoy tax-free capital gains forever.
Second, look into Opportunity Zone investing if you’re about to see a huge windfall that comes with a correspondingly huge capital gains tax bill. If you’re about to sell a house you flipped, or you’re going to sell a business, or you want to sell an appreciated stock, Qualified Opportunity Zone investing could be for you. At the very least, pay attention to what options are available and give yourself a few months (you have 180 days) to see if you can find a worthy investment for your portfolio.
Taxes And Opportunity Zones
Tax minimization is a big reason why people invest in an opportunity zone. You can move your capital gains into a qualified opportunity zone, and if you maintain your investment, your future opportunity zone profits are untaxed. That's amazing.
However, there is a reporting requirement with opportunity zones, and it can be complicated. In fact, many tax software programs (like TurboTax) don't support the reporting for it. You need to make sure you report your opportunity zone investment on IRS Form 8997.
How Can I Invest in an Opportunity Zone?
There are a few ways to invest in a Qualified Opportunity Zone (if you determine it’s right for you). First, you could invest directly in the Opportunity Zone. Buying commercial or residential real estate or some sort of franchise estate in an Opportunity Zone could pay off in the long run.
Be careful about investing in a service-based business though. More than half the company’s revenues must be generated in the Opportunity Zone to be considered a qualified opportunity.
Another method of investing is for more passive investors who have to focus on building their business or career outside of an Opportunity Zone. For these investors, investing in projects or Opportunity Zone funds could yield a nice return with minimal time investments.
The National Council of State Housing Agencies keeps a list of Opportunity Zone investment opportunities. People who are familiar with the world of crowd-sourced real estate investments may recognize a few of the funds listed on the site. For example, Fundrise has a nationwide fund of $500 million called the Fundrise Opportunity Fund.
Another investment firm, Equity Multiple, also has an Opportunity Zone investment.
Other investment opportunities showed investment options ranging from $25 million in one city or state to hundreds of millions across the nation.
Remember, these are investments in economically depressed areas, so there is no guarantee of performance. But, for the right investor, these could make sense.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.