Accounting Today: Unlock Opportunities For Tax Incentives In Opportunity Zones | OZPros

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Accounting Today: Unlock Opportunities For Tax Incentives In Opportunity Zones

Congress initiated the opportunity zones program in 2017 as part of its Tax Cuts and Jobs Act, a historic law encouraging private investment in low-income neighborhoods across the United States.

In a nutshell, it enables you to benefit from capital gains tax benefits and receive returns on investments while making a difference in disadvantaged communities.

The Tax Cuts and Jobs Act makes it incredibly enticing to channel your money into certain low-income areas known as qualified opportunity zones. These low-income census tracts exist in every state, along with the District of Columbia and each of the U.S.’s five territories.

Investors have a wealth of options for putting their capital gains to work through this program, including brownfield redevelopment, retail development, industrial development, multifamily housing or even operating businesses. These investments help provide jobs for residents living within these zones via new construction projects, housing developments, retail stores, and small businesses. Any business in a qualified opportunity zone, new or old, can receive funding as long as it complies with the opportunity zone regulations. To determine whether a particular investment qualifies for the program, check with IRS Publication 954.

Tax incentives and benefits

The opportunity zone program offers an alternative to traditional investment vehicles such as stocks and bonds. Its first benefit lies in allowing investors to put off paying taxes on the capital gains they invest in an opportunity zone until the end of 2026.

Second, investors can receive a step up in the basis for the capital gains they choose to reinvest in an opportunity fund if currently pending legislation to update the program is passed.

Finally, and most importantly, investors will not incur any gain when selling any asset owned by their fund after 10 years of holding their investment in a fund, as they will be able to elect to receive a step up to its fair market value. In other words, if a capital asset owned by the fund is sold prior to the tenth anniversary of the investment into the fund, the investor will owe taxes on whatever they gain from the sale. However, as soon as the investor reaches the 10th anniversary of their investment into the fund, when they sell any capital asset owned by the fund, they will pay no taxes on the appreciation of the asset.

Capital gains tax savings

Capital gains tax is the money owed after profiting from the sale of a capital asset. Virtually anything owned as an investment — be it a home, cars, furniture, stocks or bonds — is a capital asset.

When a capital asset is sold, the difference between the cost, or the adjusted basis, and the amount obtained from the sale is the capital gain. Capital gains realized are subject to capital gains tax. However, capital gains only occur upon the sale of the asset. For example, if you purchase a stock for $15 and then sell it later for $20, your capital gain is $5.

If an investor holds the capital asset for less than a year, their capital gain is classified as short-term, but if they hold it for longer than a year, it’s classified as long-term. The tax rate is different for these two categories. As of Feb. 11, 2020, long-term capital gains are taxed at either 0%, 15% or 20% (or 23.8%), depending on your income level.

Imagine you are an investor with $100 of potential capital gains in stocks that you wanted to reinvest in an opportunity zone when the program began in 2018; if you held that investment for 10 years, you would realize significant tax benefits. First, you would defer the capital gains tax on the $100 you made in stocks until 2026, then your basis — or cost — would be boosted by 15%, effectively bringing your $100 of taxable gains down to $85. Finally, since you held your investment for 10 years, you would not be taxed on its appreciation.

Assuming your opportunity zone investment appreciates at a rate of 7% each year, your $100 investment would be worth $176 at the end of 10 years. That amounts to a 5.8% annual return — far better than the 2.8% annual return you could have expected from other investments.

Additional layer of risk management

In addition to the favorable tax treatment received for making investments in opportunity zones, these investments open up new opportunities for risk management. There is always some level of risk involved in investing, but opportunity zones allow a unique opportunity to diversify one’s portfolio and better manage that risk.

If an investor puts money in an opportunity zone fund investing in several real estate projects, a handful of those projects may fail or underperform. Though some of the investment would be lost, the investment would still likely outperform other options like cash accounts or bonds over time.

Estate planning and wealth transfer

When estate planning, one must consider two main kinds of assets, the first of which is known as income in respect of a decedent, or IRD. IRD assets include investments such as IRAs, 401(k)s, annuities, or the deferred gains portion from an opportunity zone investment.

Non-IRD assets include investments such as stocks, bonds or real estate, which generate income when sold. If non-IRD assets are gifted while the owner is alive, the recipient is responsible for paying income tax on any unrealized capital gain when the asset is sold. If the asset is given by way of the owner’s will, the recipient will be taxed on a stepped-up value of that asset.

IRD assets, such as opportunity zone investments, receive a favorable income tax treatment while the owner is alive. An opportunity zone investment cannot be gifted to another taxpayer without triggering the need to pay the original capital gains. However, this can be avoided by gifting it to a grantor trust. Doing so ensures the opportunity zone income tax deferral on the original capital gains will remain in place until it is reported on the 2026 tax return. Even if the investment is transferred upon death, the recipient maintains tax benefits.

For example, if you gift your opportunity zone investment to a grantor trust, your heirs will assume the investment’s original tax basis but will not incur a step up to fair market value on your death. Your heirs will receive the step up in basis when the asset is sold, meaning if the asset is held for 10 years, your heirs will not pay tax on capital gains — even if the investment grows in value after death.

An investor can defer capital gains taxes on appreciated property while they’re alive and then pass those holdings onto their heirs without any additional tax burden upon receipt, which represents a significant advantage to non-IRD investments that are held directly. These investments are subject not only to income taxes, but also to capital gains taxes if sold after death.

In short, investing in opportunity zones offers a unique opportunity to save money on taxes, diversify a portfolio, and enjoy benefits such as estate planning or wealth transfer. Best of all, over 35 million people in low-income communities receive much-needed help thanks to this legislation.

Ashley Tison
Founder, OZPros

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