On December 22, 2017, Section 13823 of the 2017 Tax Cuts and Jobs Act added two new sections to the Internal Revenue Code (26 U.S.C. Sections 1400Z-1 and 1400Z-2) that provides tax incentives for investments in targeted areas in the United States through investment vehicles called Opportunity Funds. The purpose of Opportunity Funds is to promote economic development in these select communities, known as Opportunity Zones, by offering investors substantial federal tax advantages that are only available through the new program.
By investing into an Opportunity Fund, investors can not only elect to defer their existing capital gains tax liability, but also reduce existing capital gains tax liability and thereafter eliminate future capital gains tax on returns earned from the Opportunity Fund.
Opportunity Zones Program
Opportunity Zones Program
Opportunity Zones are census tracts, nominated by governors and certified by the U.S. Department of the Treasury, into which investors can invest in new projects intended to spur economic development in exchange for certain federal tax benefits.
Opportunity Funds
Opportunity Funds are investment vehicles that invest at least 90% of their capital in Qualified Opportunity Zone Properties or Qualified Opportunity Zone Businesses. The fund model enables investors to pool their resources in Opportunity Zones, increasing the scale of capital going to investments selected by the manager.
To capture the potential tax benefits offered by an Opportunity Fund, an investor must invest the gains from a sale of a prior investment (e.g., stock, bonds, real estate, a company) into an Opportunity Fund within 180 days of the sale of that investment. The investor only has to roll in the gain or profits from the sale of the investment, not the original principal of the investment. Moreover, only the taxable gains rolled over into an Opportunity Fund are eligible to receive the tax incentives. Investing in Opportunity Funds can provide three substantial potential tax advantages to investors.
Deferral of Capital Gain
A tax deferral for any capital gains rolled over in an Opportunity Fund. The deferred gain would be recognized on the earlier of December 31, 2026 or the date on which the investment in the Fund is sold.
Reduction of the Capital Gains Tax Realized
A step-up in basis for capital gains rolled into an Opportunity Fund. The basis of the original investment is increased by 10% if the investment is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years. In other words, if by December 31, 2026 an investor has held an investment in an Opportunity Fund for 7 years, then the tax on the initially deferred gain is expected to be reduced by 15%, or reduced by 10% if by then held for only five years.
No Tax On Any Capital Gains From an Investment in Opportunity Fund
In the case of any investment in an Opportunity Fund held by a taxpayer for at least 10 years, the basis of such property shall be equal to the fair market value of such investment on the date that the investment is sold or exchanged. In short, after 10 years, thereafter there would be zero federal capital gains tax on profits from the sale of an investment in an Opportunity Fund.
How Investing in an Opportunity Fund Works
To receive the most favorable tax treatment on their investment, investors are incentivized to hold their stakes in an Opportunity Fund over the long term, with the program providing the most potential upside to those who hold their investment for 10 years or even more.
Investment Timeline
A long-term investor could roughly double his or her potential after-tax return by rolling capital gains into a qualified Opportunity Fund instead of investing them into a traditional stock portfolio.
The figure above illustrates how an investor’s potential after-tax returns compare assuming a 10-year holding period, annual investment appreciation of 7%, and a long-term capital gains tax rate of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%).
For example, after 10 years an investor would see an additional $440,000 for every $1 million of capital gains reinvested into an Opportunity Fund on December 31, 2018 compared to an equivalent investment in a more traditional stock portfolio generating the same annual appreciation. Note, however, that the performance assumptions shown are for illustrative purposes only, and are not intended to reflect the actual experience of any individual investor.