December 31, 2019 marks an important deadline for opportunity zone investors: this is the last day on which they can make an investment in a qualified opportunity fund and get the full benefit of the program.
Created as a vehicle in which investment flows to opportunity zones to reap the highest possible tax benefit on deferred capital gains and to spur growth, the program has set timelines. This New Year’s Eve isn’t the only deadline that matters for OZ investors, it is just the one that happens to be front and center right now. A separate December 31st deadline exists for QOFs set up early this year: they have until this date to invest those funds in an OZ project or business.
This year’s deadline means that for investments made in a QOF before January 1st and held for seven years, investors will not pay tax on 15% of their deferred capital gains. For investments made for two years after Jan. 1st, they won’t pay tax on 10% of their deferred capital gains — still a discount, but not quite as good of a deal. Is the difference between 15% and 10% enough to push investors into QOFs in the final quarter of 2019? Feedback is mixed as many say investors are still being cautious and selective.
The thing about OZ investing is that it is best done with patient money, over many years. Each deal is different, but, as a hypothetical, if an investor realizes a $1M capital gain on the sale of an asset (could be real estate, but also almost anything else), the investor has 180 days to put that amount in a QOF, according to the Tax Cuts and Jobs Act of 2017, which authorized tax breaks for opportunity zone investments.
Assuming the investor does so by Dec. 31, 2019, tax on the $1M capital gain will be deferred as long as the QOF is active, up to seven years. Once seven years has passed, the tax will be due. Assuming a rate of 23.8% (that is, the 20% rate for high-income taxpayers plus an additional net investment income tax of 3.8%), the total capital gains tax on $1M, without the QOF tax break, would be $238K. With the QOF tax break for a seven-year hold, however, the investor would pay a capital gains tax on only $850K, saving more than $30K on its tax bill.
What if the investor waited until Jan. 1, 2020, to put that very same $1M capital gain into the very same QOF? In that scenario, at the end of seven years, the investor would pay tax on $900K, meaning a one-day delay would cost the investor roughly $12K more in taxes. That relatively small difference might not drive too many investments into QOF before Dec. 31, but there is another factor that might. There is a requirement to deploy capital within 180 days of the capital gain. This time frame can cause investors to rush into investments that might be riskier than they would otherwise.
Naturally, in the realm of tax law, nothing is ever simple, and that is certainly the case for investments in QOFs. One wrinkle to the above example is that it assumes an investor holds his or her interest in a QOF for seven years. Under current law, at least until Dec. 31, 2019, that is the way to get the highest tax break on deferred capital gains: 15% of the gain will be tax-free. But it only takes a five-year hold to not pay taxes on 10% of the deferred capital gain. That sets up another deadline on Dec. 31, 2021, because the final date to end a QOF is Dec. 31, 2026. So investors have over two years to put their money into a QOF to get the 10% break, which offers a longer time for due diligence and learning about which funds are better than others.
There’s a bill floating around Congress to extend the deadline, but no real movement on it yet. Another tax wrinkle posed by opportunity zones has to do with investors who invested capital gains in a QOF before June 28th, the program’s first important deadline. Since investors have 180 days to place their money in a QOF, those who wanted to get a tax break on a capital gain from 2018 needed to make an investment by that date. These investors are now required to invest these funds into qualified property by December 31st or else be subject to IRS penalties.
QOFs have a different timetable when it comes to the investments they have to make in opportunity zones both in real estate and in businesses located in the zones. The IRS handed down two successive sets of rules last year and this year that specified what QOFs have to do, and when they have to do it. A QOF is essentially a special-purpose entity that ensures that invested capital is employed in a property or business within a qualified opportunity zone. Per IRS rules, a QOF must hold at least 90% of its assets in qualified opportunity zone properties. In the case of QOFs formed to beat the June 28 deadline, whether they meet that standard will be measured near the end of 2019, and then each year afterward. If a QOF doesn’t meet the 90% test for any year after its formation, it has to pay a penalty for each month it doesn’t meet the requirement.
In the long run, the important tax deadline for opportunity zone investment might not be Dec. 31, 2019, or even Dec. 31, 2021, but further into the future: Dec. 31, 2028. Assuming the program stays as-is, that will be the day investors must put money into a QOF to reap a tax benefit potentially much larger than the one on deferred capital gains — the program’s other tax break eventually zeros out capital gains taxes on the investment in the QOF itself.
As it stands now, investors need to sell their interest in a QOF by Jan. 1, 2048. The program ends at the end of 2028, however, making Dec. 31, 2028, the last day to invest. The 10-year tax break might be sweet indeed. Another hypothetical example illustrates the point.
Take an investor who has put a $1M capital gain in a QOF. For the purpose of the example, say the QOF buys a series of apartment buildings in opportunity zones, adds value to them (the IRS rules specify how much) and sells them at a profit over a decade. The investor keeps the investment for 10 years. By that time, he or she is able to sell the investment for $3M. Under ordinary circumstances — and again assuming a 23.8% capital gains tax — that transaction would present the investor with a tax bill of $467K. Since the investment was made in a QOF, the tax bill at the end of 10 years would be $0.
Regardless of the upcoming deadlines to maximize potential benefits, the fundamentals of the deal have to make sense. We’ll see how things shake out at the end of this year with reports of new projects to come!
If you have any questions about this article or anything else surrounding Opportunity Zones, please don’t hesitate to contact me.
The total number of census tracts certified as Opportunity Zones by the U.S. Treasury.
Potential unrealized capital gains eligible for Qualified Opportunity Fund investment and tax treatment.
Treasury Secretary Steven Mnuchin’s estimate of private capital that will flow into Opportunity Zones.