Do Potential Tax Savings from Investing in Qualified Opportunity Zones Outweigh Any Drawbacks?

The Tax Cuts and Jobs Act (enacted in December 2017) contained a provision with special tax incentives for taxpayers making investments in economically distressed communities (“opportunity zones”). The program ultimately aims to spur economic development and job creation in these communities. The first opportunity zones were named in April 2018.

To date, over 8,700 low-income communities have been designated as qualified opportunity zones. Investing in opportunity zones provides possible tax savings for investors, but there are also several drawbacks investors should consider.

The Basics

  • A taxpayer may defer gains by investing the “deferred gain amount” (“DGA”) in a qualified opportunity fund (“QOF”).

  • Among other requirements, a QOF must hold at least 90% of its assets in property located within a QOZ.

  • The DGA must be invested in a QOF within 180 days of the property’s date of sale. (For example, Susan Jones recognizes a $250k gain on a June 30, 2018 sale of XYZ stock; to defer the $250k gain, Susan Jones must invest $250k in a QOF within 180 days of the June 30 sale date).

  • Once the DGA has been invested in a QOF, the gain is deferred until the earlier of, the date the investor sells the QOF investment or December 31, 2026.

  • If the taxpayer holds the QOF investment for five or more years, the DGA is reduced, thereby providing a tax savings (see table below):

Qualified Opportunity Zones Deferred Gains chart.JPG
  • Special Note: Since December 31, 2026 is an important trigger date for recognition of the DGA (as explained above), taxpayers would need to make an investment in a QOF by 2021 to receive the special five-plus year tax incentives or by 2019 to receive the special seven-plus year tax incentives.

Example

  • On July 15, 2018, John Smith recognized a $750k gain from the sale of various securities.

  • On November 20, 2018 (within 180 days of the July 15 sale date), John Smith invests $600k in a QOF.

  • John Smith elects to defer $600k of the $750k gain, having invested $600k in a QOF within the 180-day window. The remaining $150k of the $750k gain will be treated as a taxable gain on the 2018 tax return.

  • As of December 31, 2026, the fair market value of the QOF is assumed to be $725k.

  • John Smith holds the QOF investment for more than 10 years, selling the QOF investment for $800k on December 31, 2028.

Qualified Opportunity Zones Taxable Activity Chart.JPG

Conclusion

Although investor interest is understandably high given the possible tax savings, this program is still in its infancy and comes with potential drawbacks:

  • Higher Risk – The investments in economically distressed communities may entail a higher degree of risk, relative to more developed markets.

  • Timeline – To maximize the tax benefits, an investor needs to hold the QOF for at least five years, and ideally more than 10 years. 

  • Due Diligence – An investor must have a high degree of confidence that a QOF will hold at least 90% of its assets in a QOZ property; otherwise, any potential tax savings could be jeopardized.

  • Opportunity Cost – The future return potential of a QOF (combined with potential tax savings) should be compared to the future return potential of other investment opportunities.

  • Clarity – As of this writing (early October 2018), the IRS and the U.S. Department of the Treasury have yet to release final guidance (although it is expected shortly).

Interested investors are encouraged to review final IRS and the U.S. Department of the Treasury’s guidance and wait for this new space (and offerings) to mature further prior to making an investment.

Are you interested in invest in an opportunity zone? Contact one of our advisors at Fi3 for more information.