A series of opportunity zones created by the Tax Cuts and Jobs Act (TCJA) of 2017 offers those who invest in projects in these zones a new tax benefit that is unprecedented. The tax benefit could also have a positive impact on targeted communities, but there are risks associated with opportunity zone investments and the regulations involved can be complicated.
Internal Revenue Code (IRC) Section 1400Z-2, enacted as part of the TCJA, created a special rule for the treatment of long-term capital gains that are reinvested into qualified opportunity funds, qualified opportunity zone property, or qualified opportunity zone businesses. When you hold an appreciated capital gain property and sell that property, you normally realize the gain. But if you reinvest the gain into one of the opportunity categories mentioned above, you do not recognize the gain currently. The concept may make more sense with an example.
Say you have stock worth $2 million. Assume your adjusted basis (what you paid for the stock) is $800,000. If you were to sell that stock, you would realize a $1.2 million gain. If you are in the highest long-term capital gain tax bracket, the tax would be 20% ($240,000). You would have $2 million minus $240,000, or $1.76 million, after the sale and tax. With the opportunity zone tax break, if you would invest at least the $1.2 million gain in one of the above three investments within 180 days of the sale, you can defer recognition of the gain in the year of sale. The other $800,000 (the original basis) can be invested here or elsewhere.
Because you didn’t pay tax on the gain, your adjusted basis (or cost) in the opportunity zone investment is zero. If you remain invested in those assets for five years, the adjusted basis of your investment is increased to $120,000, or 10%, without paying any tax. Stay for two more years (a total of seven) and your basis increases by another $60,000 (5%) to $180,000 (15%). If you divest at that point, you would recognize the initial $1.2 million gain reduced by the $180,000 of adjusted basis. So, at the end of seven years, you would only pay tax on $1.02 million of gain when you divested (depending upon the value of your interest when you divest). You must recognize the remaining gain ($1.02 million) in this example and pay the 20% long-term capital gain tax of $204,000.
The deal can be even better. If you stay invested for a total of 10 years, assume the fair market value of your investment grows to $3.112 million (a 10% reinvested growth). The law allows you to adjust your basis in the investment to the fair market value on the date you sell it – that’s the full $3.112 million. If you sell the investment for $3.112 million, your adjusted basis would be $3.112 million and the gain you recognize is zero. This example assumes a 10% growth rate after any tax paid associated with the annual income generated. The basis calculation assumes any taxable income earned by the investment is distributed currently and the appreciation arises from the increase in fair market value, as differentiated from reinvested earnings.
Not only would you save 15% of the tax on your original $1.2 million gain, but you would also save tax on the appreciation. You saved the tax on another $1.912 million of gain. That’s $382,400 at the 20% rate on top of the $36,000 already saved. That represents a total tax savings of $418,400. Note, if you invested the original $800,000 in basis, that investment is tracked separately, and that investment does not enjoy the step-up to fair market value benefit.
Marry the potential tax saving with the gift, generation-skipping, and estate tax modifications from the TCJA and you can pass that savings on to your heirs. For 2019, the exemption amount associated with the unified credit for all three is about $11.4 million for each spouse.
A word of caution: the law is complicated, and each of the three types of opportunity zone investments must be evaluated for the inherent level of risk and the level of return earned as a component of an overall investment portfolio. To be an eligible opportunity zone investment, the investment must be in a fund that owns qualified opportunity zone property or businesses, or in the actual property or business located in an opportunity zone.
This legislation significantly encourages investment in lower income areas to create businesses and jobs. It certainly creates the potential for great investments and powerful tax breaks, but the flip side is the reward of impactful investing that could change a whole community’s well-being for the better. Gov. Tom Wolf was quick to nominate opportunity zones when the law was enacted, and you can find the list of Pennsylvania opportunity zones online under Programs and Funding on the Department of Community and Economic Development website.
Edward R. Jenkins Jr., CPA, CGMA, is professor of practice in accounting for Pennsylvania State University in University Park, managing member of Jenkins & Co. LLC in Lemont, and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.