Last time we spoke about a powerful tax strategy—1031 exchanges. Now let’s discuss another option: Investing in opportunity zones.
In 2017, Congress updated tax law. At the time, people focused on how the law slimmed corporate tax rates. But it also created a new tax break—Opportunity Zone investments—that reduces current capital-gain tax and wipes away future capital-gains tax. These breaks can mean thousands for the average person and hundreds of thousands for the wealthy. Want to know how?
We’ll get to that shortly. But let’s begin with some background. The tax incentive was designed to solve two problems at once. Problem 1: American taxpayers had about $6 trillion (yes, with a “t”) in unrealized capital gains sitting on the sideline because of (high) tax rates. Problem 2: While unemployment is low and the stock market has soared since the Great Recession, the recovery’s benefits have overwhelming went to a handful of metro areas.
So, how did Congress kill two birds with one stone? By offering a massive tax break for people investing their portion of the $6 trillion in unrealized gains, but only if they invest in less affluent areas that have been designated as an Opportunity Zone—including much of the CNMI.
How does the incentive work? In three stages. The first stage defers tax on the investment where you’ve already generated a capital-gain tax. The second stage rolls back up to 15% of your capital-gains tax. And the third stage wipes out your capital-gains tax for the new investment you made using your original capital gains. Combined, these three stages can add up to huge tax savings.
Now for the details.
Unlike some tax breaks (namely 1031 exchanges), the Opportunity Zone incentive applies to capital gains across a broad range of investments, including stock, real estate, and personal property.
Better yet, you only need to reinvest the gain, not the full sale price. So, for example, if you bought a stock for $10,000 and sold it for $11,000, you can keep your original investment of $10,000 and reinvest the $1,000 of capital gains.
But don’t wait too long: The clock is ticking. You must invest that money within 180 days of recognizing the gain (which is accountant-speak for the moment an investment was sold for more money that it was bought). And you must invest the gain in a corporation or partnership that was specifically created to invest in Opportunity Zones and has at least 90% of its assets in Opportunity Zones.
Once you’ve made the investment, you can enjoy three benefits.
First, you can, in effect, get an interest-free loan from the IRS. That’s because you don’t have to pay any tax on your original gain until you sell Opportunity Zone investment or December 31, 2026, whichever happens first.
But it gets better. Assuming you hold onto your Opportunity Zone investment for five years, then the amount you will eventually have pay on the original gain will drop 10%. And if you keep holding for another two years (7 in all), then the drop will go from 10% to 15%.
And best for last: If you hold your investment for 10 years, then you don’t have to pay any capital gains on your Opportunity Zone investment. None.
So, if you do it right, you can use money that you normally would have paid to the IRS to fund an investment. Seven years later, you would pay the tax, but only 85% of what you would have originally paid. Ten years later, you would not have to pay any capital-gains tax on the new investment. And, as icing on the cake, you would (hopefully) receive regular cash payments from your Opportunity Zone investment throughout those 10 years.
To put that in concrete terms, let’s look at an example. Sal buys a home for $100,000 in 2010 and sells it for $200,000 in 2019. Assume the gain is $100,000 (for simplicity), which Sal puts into an Opportunity Zone investment. Ten years later, Sal sells his investment for $200,000.
In this scenario, Sal’s capital gain for the original investment was $100,000. But since he held his Opportunity Zone Investment for more than seven years, he only needed to pay 85% of the original capital gain. So, he only needed to pay capital-gains tax on $85,000 rather than $100,000. Thus, assuming a capital-gains tax rate of 20%, he paid $17,000 in taxes rather than $20,000—a savings of $3,000. And since he ultimately held the Opportunity Zone investment for 10 years, he paid no capital-gain tax on the $100,000 gain from that investment—a savings of $20,000 (again assuming a 20% tax rate). That’s $23,000 in all.
Not bad, eh. And yet the number is actually better. How so? Because for 7 years, Sal didn’t pay tax on his original investment. That allowed the deferred capital-gains tax ($20,000) to make him extra money in the new investment. Assuming a 7% return, over those 7 years the deferred taxes grew to a little over $32,000, all tax-free. That’s $12,000 more than if Sal had not invested his capital gains, bringing the total benefit to $35,000.
Sounds great, right? It could be. But like anything, some caution is needed. Don’t invest in something just because it is an Opportunity Zone investment. Make sure the investment is sound. And make sure it has a good chance of turning a profit: Because while the Opportunity Zone incentive will supercharge a winning investment, it won’t save a losing one.
Jordan Sundell is a lawyer primarily practicing business and real-estate law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including JZ Group. His columns—focused mainly on real estate and small business—are published every other Tuesday. Contact Sundell at firstname.lastname@example.org.