Contributed by Adam Lazarus, CPA, Michael Gershon, CPA, MBA, MS and Patrick Daly, CPA of Citrin Cooperman.
The Tax Cuts and Jobs Act of 2017, has been regarded as the most far-reaching tax law passed in more than 30 years. This law has so many provisions that one attractive feature has been largely overlooked in media reports: the creation of Opportunity Zones.
As an investor, you may find many “opportunities” in these Opportunity Zones. For instance, you can defer paying income tax on the capital gains you take. These gains could result from profitable sales of securities, real estate, family business interests, and so on. The deferred gains eventually will be subject to tax, but the tax you’ll pay may effectively be reduced. In addition, any post-acquisition gains from qualified investments under this portion of the new law could avoid income tax on a sale or exchange, after a holding period of at least 10 years.
There are no limits on the amount of tax you can save from these Opportunity Zone tax benefits. In addition, there are no income-based phase-outs, as may be the case with other areas of the tax code. High-income taxpayers can use Opportunity Zone tax breaks in full.
Each state in the U.S. was able to nominate Opportunity Zones, which must have been low-income census tracts, as determined by median family income. Nominated census tracts were submitted to the federal Treasury Department for consideration, and more than 8,700 census tracts have been approved in all 50 states.
To qualify for Opportunity Zone tax benefits, investments must be made in the approved census tracts. Investors’ dollars can go into local businesses, new real estate development, or improvement of existing investment property. Holdings that may qualify include real property, company stocks, and partnership or limited liability company (LLC) interests. The acquired assets must be substantially improved following the acquisition, with their new adjusted basis in excess of the basis of those assets at the acquisition date. (See the accompanying example of how an Opportunity Zone investment might provide tax benefits to investors.)
HIGH RISKS, LOW PRICES
Congress created Opportunity Zones to stimulate investment in low-income areas of the U.S. Any real estate or small business investment has risk, but investments in these areas may be especially perilous due to depressed local economic conditions. On a positive note, a lack of demand may make it possible to buy in at reasonable values. If enough money flows into a given zone, and the local economy revives, today’s dimes may turn into untaxed dollars a decade from now. That’s especially true if the small companies and properties being financed are selected and overseen by experienced real estate and venture capital professionals. What’s more, any loss of value in an Opportunity Zone investment may decrease the tax owed from a prior rollover, further reducing the risks.
FOCUSING ON FUNDS
Generally, individuals interested in Opportunity Zone ventures will invest through a Qualified Opportunity Fund, which might be structured as an LLC. To be eligible for the available tax incentives, at least 90% of the fund’s assets must be invested in an approved Opportunity Zone.
Opportunity Zone assets must be used in a trade or business that was acquired by the fund from an unrelated party in 2018 or later. Fund management will be responsible for selecting properties or businesses, and take an active role in overseeing operations.
THE CITRIN COOPERMAN CONTRIBUTION
Citrin Cooperman participates in the bipartisan group that proposed the tax legislation dealing with Opportunity Zones, in order to address economic challenges in the marketplace. We will continue our efforts within this group, working with the Treasury Department to help generate tax-efficient rules and procedures for taxpayers.
At Citrin Cooperman, we will follow the promised official guidance regarding Opportunity Zones and keep clients informed of the evolving process. As Opportunity Zone investments appear, we have the ability to review offering memorandums and other key documents for deals under consideration. Our experience in analyzing such investments can help clients decide if a proposed offering might improve their tax position as well as possibly deliver reasonable long-term results that are aligned with their risk tolerance.
What’s more, Citrin Cooperman can model various scenarios and project a return on investment (ROI), both pre-tax and after-tax, for specific clients. That projected ROI can be compared with the anticipated results of other potential strategies, such as tax deferred exchanges under Section 1031 of the Internal Revenue Code.
For operators forming Opportunity Zone funds, we can assist at all stages of the arrangement. Our expertise in these areas can help structure transactions that comply with regulations, supporting tax advantages while offering significant economic potential.
POTENTIAL LONG-TERM PAYOFF
To illustrate how to obtain Opportunity Zone tax savings, assume that Ms. Smith is an experienced real estate investor. One of Ms. Smith's ventures recently closed, and Ms. Smith emerged with a capital gain of $150,000. (Long- or short-term capital gains may be used.)
Ms. Smith then invests her $150,000 gain in an LLC that will acquire commercial property within an Opportunity Zone, and make substantial improvements. This reinvestment takes place within 180 days of Ms. Smith realizing the $150,000 gain, as required by the Opportunity Zone rules. This Opportunity Zone reinvestment allows Ms. Smith to avoid immediately paying the tax on her $150,000 capital gain.
Fast forward five years to 2023. Ms. Smith gets to step up her basis in her former investment (the one sold in 2018) by 10% of the $150,000 gain: $15,000.
After two more years, in 2025, Ms. Smith can step up her basis in the older investment by another 5% of the gain: $7,500.
At the end of 2026, Ms. Smith will pick up the obligation to pay the tax she has deferred from 2018. In this example, her basis in that prior deal will have been increased by a total of $22,500, reducing the taxable gain she will report and the tax she will owe. Ms. Smith might have an even lower tax bill, if the current value of her Opportunity Zone investment is less than the capital gain she can now report from the old investment.
On the other hand, Ms. Smith’s Opportunity Zone investment may have gained dramatically. Any post- acquisition gain that Ms. Smith realizes from her Opportunity Zone venture will be tax-free, if the holding period is 10 years or longer.
Adam Lazarus is an audit partner with more than 15 years of experience in the areas of audit, tax, and business consulting. He serves clients primarily in the real estate industry, including developers and operators. He can be reached at firstname.lastname@example.org
Michael Gershon provides his clients, including high net worth individuals, family groups and closely held businesses, with income tax planning and compliance, business advisory services, succession planning, and wealth preservation planning. He can be reached at email@example.com
Patrick Daly, a partner in the firm’s New York City office, has an extensive background in taxation and accounting, which includes various tax compliance and consulting services. He can be reached at firstname.lastname@example.org