In December of 2017, the Opportunity Zone program was introduced as a new, investing tool included in the Tax Cuts and Jobs Act. Under the program rules, state governments can designate low-income and economically distressed areas as Qualified Opportunity Zones (QOZs). Over 8,700 Opportunity Zones can be found across all 50 states.
In these communities, investors are now eligible for attractive and preferential tax treatment. This economic tool hopes to spur economic development in these areas, benefitting both the community and the investor.
1. What are the Tax Incentives for Qualified Opportunity Zones (QOZs)?
This program allows investors to defer all QOZ capital gains taxes, through December 31st, 2026, so long as they invest the profits into a Qualified Opportunity Fund (QOF). The QOF basis increases the longer an investment is held. If the investment is held for 5 years, then the capital gains tax decreases by 10%, if the investment is held for 7 years, then the capital gains tax decreases an additional 5%. If the investment is held for 10 years, the QOF appreciation is never taxed. On top of these benefits, investors have the added gain of knowing that their investment is reinvigorating communities that have never seen substantial economic boosts.
2. How Returns Can be Improved in Qualified Opportunity Funds (QOFs)
Let's compare an investment made in a QOF (with added tax incentives) versus an investment in a non-opportunity zone. The QOF tax incentives include:
- A deferral of paying tax on the original capital gains until reported on the 2026 tax return.
- A discount on the original, deferred capital gain tax on the 2026 tax return.
- A step-up in basis, after 10 years, to the QOF investment's fair market value, on the date of sale or exchange.
To achieve an "apples-to-apples" comparison between these two investments, one should consider the "after-tax" cash proceeds on both the front and back-end analysis. After-tax cash is a practical benchmark, in the analysis, as it is the amount that an investor can actually use.
3. Did You Know? Depreciation and Cost Segregation Benefits can Increase QOF Returns.
In addition to the capital gains savings, investors can meaningfully increase their returns through depreciation. Current regulations grant investors the ability to avoid depreciation recapture on their 10-year QOF investment, when sold. Investors may also take advantage of the Cost Segregation strategy. Cost Segregation is an IRS-approved, tax deferral strategy that enables owners to accelerate their depreciation schedule by reclassifying their assets. These assets typically depreciate over a period of 27.5 to 39 years, but can be reclassified to tangible personal property, which depreciates over five, seven, or fifteen years.
After an asset is purchased, the sponsor may hire a qualified accounting or engineering firm to deploy a cost segregation study. By performing this study, building owners can identify assets, within the building, that qualify for bonus depreciation. Those assets may be depreciated during their first year of service. The Tax Cuts and Jobs Act increases the bonus depreciation percentage, from 50% to 100%, for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. Thanks to these changes, any assets identified in a cost segregation study, with a depreciation treatment under 20 years, may generally be deducted fully in year one.
4. Consider This Before Investing in a QOZ. Is This the Right Move for You?
Investing in an Opportunity Zone can come with attractive incentives, but one should make sure that the investment makes sense without the added benefits. The tax benefits should just be seen as a bonus for making a solid investment.
- Complete thorough due diligence on each project or invest with a professionally managed fund to increase your returns.
- Roll your capital gains into a QOF to defer and possibly eliminate tax burdens.
- Retain your access to the initial principal.
- Substantially increase your returns through the use of fully-realized depreciation benefits.
Thank you for reading and remember to invest with passion and transparency!
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