Opportunity Zones

Asset Management, Taxes June 26, 2019

Opportunity Zones

Part of the Tax Cuts and Jobs Act included the U.S. Investing in Opportunities Act which established the Opportunity Zone program. This program was created to encourage investments and job creation in economically distressed areas.

Opportunity Zones are census tracts nominated by the states and certified by the Internal Revenue System (IRS) and the U.S. Treasury. To date, there have been over 8,700 Opportunity Zones certified in all 50 states and five U.S. territories. These communities have a median family income 37% below the state average and unemployment 1.6 times higher than the national average.

To spur investments in Opportunity Zones, investors are given a capital gains tax incentive. Typically, when an investor sells an appreciated asset, they are required to pay capital gains tax on the appreciation. The Opportunity Zone program allows an investor to defer this capital gain by reinvesting the proceeds into a Qualified Opportunity Fund within 180 days of realizing the gain. A Qualified Opportunity Fund is an investment vehicle set up as a corporation or partnership that invests at least 90% of the assets in Opportunity Zones. Investors cannot invest in properties directly and must utilize Qualified Opportunity Funds.

Investments rolled into Qualified Opportunity Funds and held for five years will receive a 10% step up in basis. If the investment is held for seven years, there will be an additional 5% increase in basis. On December 31, 2026, investors must realize capital gains on their initial investment. Therefore, in order to benefit from the 15% increase in cost basis, investments must be made in Qualified Opportunity Funds by December 31, 2019. If the investment is held for 10 years, there will be no federal capital gains tax on any appreciation in the Opportunity Fund Investment.

For example, in April 2019 an investor sells a $1 million investment with zero-basis and reinvests the capital into a Qualified Opportunity Fund within 180 days. This allows them to avoid paying $200,000 in capital gains tax in 2019 (assuming the top 20% long-term capital gain rate). If they hold this investment until December 31, 2026, they will only be required to pay tax on $850,000 of the initial $1,000,000 investment. At the current capital gains rates, they would avoid $30,000 in taxes due to the 15% increase in their cost basis. If they hold the investment until April 2029, any appreciation in the Qualified Opportunity Fund will be free of tax.

This program has the potential to drastically improve many impoverished areas while creating tax benefits for investors. But it should be noted that Qualified Opportunity Funds charge fees which can be quite high, often in excess of 1% annually. Furthermore, the rush to get invested in the short time window to maximize tax benefits may create some frothiness in the Opportunity Zone market. Similarly, investors forced to realize gains simultaneously in 2026 could depress fund prices at that time.

Investing in Opportunity Zones may be worthwhile for investors who have assets with very low basis. If you think investing in a Qualified Opportunity Fund makes sense for you, please contact us.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.

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