Breaking Down the Benefits of Investing in the Opportunity Zones Program
Last week’s New York Times article described the new Opportunity Zones Program as “an attempt to grapple with a yawning hole in the recovery from the Great Recession: the fact that, in huge swaths of the country, the economic recovery has yet to arrive.” The new program was created as part of tax reform, and offers incentives to private investors taking equity stake in communities sitting at the nexus of need and opportunity.
Opportunity Funds: Market-Driven Impact Investment Vehicles
An estimated $2.2 trillion in unrealized capital gains from profitable investments in stocks and mutual funds sit on the books of individuals and corporations. The Opportunity Zones Program looks to tap this capital for economic growth. The pitch? Reduce and temporarily defer federal taxes on the proceeds of selling these assets in exchange for providing equity investments in small businesses and real estate in distressed communities.
Tax benefits are associated with investing through new vehicles called Opportunity Funds, yet there are few parameters on the terms of these investments – risk profile, return, etc. – because the program is designed to optimize flexibility, allowing it to adapt to market demand. However, eligible asset classes are identified in the statute – each of which will vary in regard to market risk.
The statute also outlines three types of benefits associated with Opportunity Fund investments, which create breaks at year 5, 7, and 10. Due to the nature of the laddered benefits, most investment options will align on term (5-, 7- and 10-year holds).
What Investors Can Expect
Temporary Deferral of Capital Gains Taxes: You will not be taxed on the gains invested in an Opportunity Fund until you exit the fund or December 31, 2026, whichever comes first. This may be an over-simplification, but think of it like a 1031 exchange except eligible investments are limited by geography, go beyond real estate assets, are aggregated in a fund structure, and the deferral cannot be indefinite because there is a deferral deadline.
Step Up in Basis in Years 5 and 7: Investments held for a minimum of 5 years will be taxed at reduced rates – 90% for investments held at least 5 years (10% basis increase) and 85% for investments held at least 7 years (15% basis increase).
Tax-Free Earnings After Year 10: If you hold an investment for 10 years, gains accrued on your Opportunity Fund investment during that 10-year period will not be taxed. It’s a permanent exclusion from taxable income.
Illustrating These Incentives in Practice
As Treasury embarks on the process needed to implement this program, it is worth noting that the first benchmark investors will look to is December 2019. In order to take full advantage of the 7-year tax deferral, funds need to be invested 7 years prior to the deferral deadline of December 31, 2026.