A New “Secret” Tax Benefit for Investors You May Never Heard Of

Do you own highly appreciated stock or a collectible you consider selling?

How about a large upside in your cryptocurrency account that is now trackable by the IRS? 

Are you holding on to an expiring stock option that has gone high in value and you plan to exercise and sell but are afraid to get hit with the huge tax bill?  

Did you do well on the sale of a real estate investment and want liquidity from the sale rather than tying up the cash in a like-kind exchange?

What if you were offered to defer some of these capital gains for up to 8 years? What about permanent tax elimination? 

Does this sound too good to be true? 

The Tax Cuts and Jobs Act of 2017 and effective through 2026, includes a tax benefit that hasn’t been widely discussed. Yet. 

The tax benefit is for investing in Opportunity Zones. The reason it hasn’t been widely discussed is the investment community has been waiting for guidelines on how to implement the rules. On October 19, 2018, the IRS issued proposed regulations for investing in Opportunity Zones, and while, they don’t answer some of the more peculiar questions, the rules are pretty straightforward for typical real estate residential and commercial property investments. 

In short, the Opportunity Zone incentives provide capital gain deferral if you reinvest the gain from sale of a capital asset like stock or piece of real estate into an investment in real estate or an investment fund operating within one of the designated opportunity zones. 

It sounds like a like-kind exchange, but it isn’t limited to just real estate. Section 1031 exchange isn’t going to help you out if you cashed out on a bunch of highly appreciated stock. Moreover, if you don’t want to recognize any gains in the exchange you can’t take any ANY cash from the transaction. (Monetized installment sales as an alternative deserve a separate analysis in this context.) Thirdly, you only reinvest the gains, not the entire sale proceeds. 

For example, you sell a building for $2M with a basis of $500,000. You will recognize gain of $1,500,000. In the like-kind exchange you will have to reinvest the entire $2M into a “like” property to defer gains. With the Opportunity Zone investment, you will sell the building for $2M, reinvest $1,500,000 and walk away with $500,000 cash. Not a bad deal! 

Moreover, if you keep your investment for 5 or 7 years, 10% or 15% of the reinvested gain, respectively, will be forgiven. And if you hold the investment for 10 years, all future gains will be permanently erased! 

Another great perk that would be rarely available in the tax incentives world is that the government gives you 6 months to make up your mind or identify a potential investment opportunity. If you recently sold stock or real estate you still have time to reinvest a portion of proceeds into a fund investing in OZs and still defer/exclude your gains. The extra 180 days give you flexibility, a chance to make more money on a short-term deal in the interim, pay off loans, and still have cash to reinvest. As you see, the upsides are numerous.  

One of the most notable conditions of qualifying for the OZ incentive is that you cannot make a direct investment in the property - the property has to be acquired through a “qualified fund”, an entity that…. self-certifies (!) to be a “qualified fund”.  

Qualified opportunity zones are designated by the governor for each state. For example, a list of California ones can be found on a California Department of Finance website. Typically, these zones are economically depressed and primarily commercial. However, many of them have already become gentrifying hotspots – they will offer the biggest benefits for the investors. For example, in San Francisco, SoMa qualifies even though it already has a Whole Foods, Trader Joe’s, and REI, as well as the new headquarters of AirBnB, Uber, and Pinterest. 

Remember that California has not conformed to this federal tax law, so gains reinvested into OZs will continue to be taxed by California. Well, in one instance, California does not recognize exclusion from gains of startup stock, but this does not prevent taxpayers from reaping the federal benefits. 

There are very few fund managers in this country who are already offering Qualified Opportunity Funds. I’d be more interested to seeing small syndication partnerships getting more traction in this area. 

Needless to say, there is always inherent risk with any type of investments but when it comes to Opportunity Zones, the additional ROI from tax subsidies will balance out the many unknowns that come with the current real estate market outlook.