The real possibility of higher capital gains rates has fueled interest by investors in opportunity zone funds.
While Code Section 1400Z, providing for the funds, was slipped into the Tax Cuts and Jobs Act late in the legislative process and with little fanfare, it quickly became popular with investment advisors.
“There have been several rounds of proposed regulations, final regulations and changes from COVID,” noted Paul Gevertzman, partner and leader of Top 100 Firm Anchin’s economic opportunity zones group. “A little over 8,000 zones were designated as qualifying for the benefits, with the idea of helping areas that needed development and investment.”
The initial incentive was the deferral of capital gains placed into an opportunity zone fund, with 15% forgiveness if the investment was held for seven years, until 2026. “That’s no longer possible, but an investor can still get a 10% ‘haircut’ on the taxable amount of their investment if they hold it for at least five years by the end of 2026,” he said. “That’s a secondary benefit that goes away after 2021.”
The real benefit is the 100% exclusion of tax on the appreciation of assets placed into the fund, Gevertzman said, noting that the 10% forgiveness after five years applies to the gain on the sale of assets put into the fund, while the entire exclusion from tax applies to any appreciation after the amount is in the fund.
“If you sell stock in Apple and invest the capital gain in a fund in 2026, you would pay tax on the original gain, minus 10% if you held it for five years. But in 2031 when that property has appreciated by a multiple of what it’s now worth, you get to step up the basis on its fair market value and therefore pay no tax on the appreciation in the fundholding the investment. That was always the ‘home run’ with opportunity zone funds.”
Investors should resist the pressure to rush into an investment without fully understanding the risks, Gevertzman cautioned. “This can happen due to the pressure generated by the requirement to deploy capital within 180 days of the sale of the asset giving rise to the gain. That 180-day requirement is easy to meet if it’s your own gain. But if you invested in a partnership that had capital gains, the calculation of the 180 days is different. If you know the actual date and the partnership itself wants to defer, the partnership can invest the asset and the gain comes through on the K-1s. The 180 days can be calculated from the date of the actual transaction, the last day of the partnership’s tax year, or the original due date of the return, without extensions. The reason is you don’t know if you have a gain until you receive the K-1.”
If the investor has a net loss, they can still use the gain to make the investment, Gevertzman indicated. “If you have a gain of 100 on Apple and a loss of 100 on Boeing, you can use the capital gain on Apple to put into the fund,” he said. “The real goal is to get the forgiveness of tax on the appreciation.”
“A few states have not followed the federal treatment of qualified opportunity funds,” Gevertzman noted. “And New York decided that, effective in 2021, they would pull out of the program for new investments. They’re the first state to do this. It’s based on the misconception that only the wealthy pay capital gains tax.”
It’s important that investors not pick their investment just because of the tax benefits, Gevertzman advised. “A qualified opportunity zone fund has the ability to take a good investment and make it a great investment. But it will never take a bad investment and make it a good investment.”