The 2017 Tax Cuts and Jobs Act created one of the greatest tax-minimization opportunities since the 1981 Reagan cuts, Qualified Opportunity Zone Funds (OZ Funds).
OZ Funds are designed to spur economic development and job creation by creating tax incentives to encourage investment in businesses located in economically-distressed communities. In return for these investments, investors can receive tax deferrals and possible elimination of capital gains taxes on their OZ Fund investments.
This article is written for investors and investment advisors who are not tax specialists. We will provide a summary of OZ Fund tax benefits and identify factors you or your clients should consider when making an OZ Fund investment. Let’s get started with an example that will demonstrate the three key tax incentives offered by OZ Funds.
Assume you sold stock in 2018, generating capital gains of $100,000. If, within 6-months of selling this stock[i], you invest these capital gains into an OZ Fund, you could receive the following tax benefits:
- Tax Deferral for Capital Gains Invested in an OZ Fund
You can defer paying taxes on this capital gains to the extent your gains are invested into an OZ Fund. The taxes on the $100,000 stock gain will be deferred until the earlier of: (i) December 31, 2026; or, (ii) the date on which you sell the OZ Fund investment.[ii] That’s a potential 8-year tax deferral.
- Basis Step-Up for OZ Fund Investments held for 5 or 7 Years
If you hold the OZ Fund investment for at least 5 years, your basis in the OZ Fund will be increased by 10% of your deferred gain. In our example, this is a $10,000 step-up in your OZ Fund basis. (i.e. $100,000 deferred gain X 10% = $10,000). If you hold the OZ Fund for 7 or more years, your basis is increased by 15% of your deferred gains ($15,000). This basis step-up reduces potential future taxable gains from the sale of the OZ Fund.
- Exclusion of Gains for OZ Fund Investments held for 10 Years or more
If you hold the OZ Fund for 10 years or more, you won’t be taxed on any capital gains from the sale of this OZ Fund. For example, if you sell the OZ Fund in 2029 for $150,000, none of the $50,000 gain would be taxable. It is important to note that OZ Fund provisions are elective; hence, if, at the time of sale, your OZ Fund basis exceeds its sales price, the election should not be made so that the loss can be recognized.
Let’s look at a couple of detailed examples to see how this works.
SCENARIO ONE – Opportunity Fund Investment:
Meet Ichabod and Griselda. They are a married couple with ordinary income (e.g. wages and interest) of $300,000 and capital gains of $100,000 from the sale of stock. They have decided to invest this capital gain into an OZ Fund which, to simplify our analysis, appreciates at a constant annual rate of 4%. Let’s assume they hold their OZ Fund for 11 years, selling it in 2029 for $154,000. Below are the tax benefits of this investment.
Temporary Deferral of Capital Gains Tax on Sale of Stock – Ichabod and Griselda will defer paying taxes on their $100,000 stock gain until 2026. (Remember, the deferred capital gains taxes must be paid by the earlier of 2026 or the year they sell their OZ Fund investment, 2029.) This tax deferral saves our investors $18,800 ($15,000 capital gain tax + $3,800 net investment income tax) on their 2018 income taxes, allowing them to use these tax dollars to partially fund their OZ Fund investment.
Permanent Exclusion of Opportunity Fund Gain in 2029 – As noted above, at 4% annual growth, the OZ Fund will appreciate to approximately $154,000; however, because Ichabod and Griselda held their Opportunity Zone investment for 11 years, none of this appreciation is taxable.
In summary, our investors receive:
- An eight-year deferral on their 2018 capital gains (i.e. the 2018 stock gain of $100,000 is taxed in 2026)[iii]; and,
- An exclusion of all capital gains taxes on the appreciated OZ Fund investment[iv].
The 4% annual appreciation plus the tax benefits generates an after-tax return on investment of 4.5%. Sound good? Before deciding, let’s look at another scenario.
SCENARIO TWO – Alternative Investment:
Ichabod and Griselda reinvest their 2018 capital gains in an investment that is not an OZ Fund. Let’s call this the “alternative investment”. If this alternative investment also appreciates at 4% , their after-tax return on investment will be 3.4%. The OZ Fund investment generates a better after-tax return because of two factors:
- Deferring the tax payment of the 2018 capital gain of $100,000 until 2026; and,
- Exclusion of capital gains taxes on the sale of the OZ Fund.
The chart below details the tax calculations of these two scenarios.
Does this mean everyone should invest in OZ Funds? No, for the following two reasons:
- It is unlikely that the OZ Fund and alternative investment will appreciate at identical rates. Rather, it’s probable you’ll find alternative investments with greater appreciation potential. However, using the facts from our example, your alternative investment would need to appreciate at an annual rate of 5.4% to outperform an OZ Fund with a 4% appreciation rate.
- The number of years you plan to hold the OZ Fund and your tax bracket in the year of sale will significantly impact your after-tax returns. If you plan to hold your investment for less than ten years, an OZ Fund investment is probably not a good fit.
Another non-tax factor you might want to consider is social impact returns. A growing number of investors are looking for more than economic returns… they seek investments that generate positive social impacts. For example, a group of our clients are investing in early childhood education centers funded by OZ Funds. These clients are using the OZ Fund tax benefits to enhance economic returns of their community-focused investments.
- The 2017 Tax Act created Opportunity Zone Funds.
- OZ Funds allow clients to defer taxes on current capital gains PLUS reduce or eliminate taxes from the subsequent sale of the OZ Fund investment.
- OZ Funds can be a valuable tool for enhancing after-tax returns of social impact investments.
OZ Funds are new; hence, their tax structures are not completely defined (e.g. the first set of proposed regulations were released on October 19th). New OZ Fund investment opportunities are being created; however, they should be carefully vetted for tax compliance and economic viability. We are working with the MICPA Tax Task Force, the Opportunity Zone Working Group, independent investment advisors, foundations and nonprofits regarding OZ Fund structures and investment strategies. Please feel free to contact us at OZFunds@insights3.com with questions or ideas. We are happy to share as we continue to learn.
At a Glance
The 2017 Tax Cuts and Jobs Act created one of the greatest tax-minimization opportunities since the 1981 Reagan cuts, Qualified Opportunity Zone Funds (OZ Funds). The three major tax benefits are:
- Tax Deferral for Capital Gains Invested in an OZ Fund: Investors can defer paying taxes on the capital gains invested into an OZ Fund until the earlier of: (i) December 31, 2026; or, (ii) the date on which the OZ Fund investment is sold.
- Basis Step-Up for OZ Fund Investments Held for 5 or 7 Years: Investors who hold an OZ Fund investment for at least 5 years or 7 years, receive a basis step-up of 10% or 15% of the deferred gain.
- Exclusion of Gains for OZ Fund Investments held for 10 Years or more: If an investor holds the OZ Fund for 10 years or more, gains from the sale of the OZ Fund are tax-free.
Click here to access our OZ Fund Investment Comparison Calculator, which compares the after-tax returns of an OZ Fund to a fully taxable investment.
[i] 26 U.S. Code Section 1400Z-2(a)(1)(A). The taxpayer must invest the capital gains in a qualified OZ Fund with 180 days of the date of sale or exchange.
[ii] 26 U.S. Code Section 1400Z-2(b)(1). Per 1400Z-2(a)(1), the capital gain must be invested in a Qualified Opportunity Zone Fund within 6-months to qualify for any of the OZ Fund tax benefits.
[iii][iii] The new law can be interpreted to allow our investors to, not only defer, but reduce or eliminate the capital gains taxes from their 2018 stock sale. However, we are waiting for IRS regulations for clarification.
[iv] 26 U.S. Code Section 1400Z-2(c). Per 1400z-2(b)(2)(B)(iii) and (iv),OZ Fund investments held for 5 and 7 years receive partial reduction from capital gains taxation upon sale.