An investment is only as good as its returns – its after-tax returns, to be precise. Unfortunately, we seldom have much control over the after-tax part of the equation, taking it for granted that Uncle Sam just gets his cut every year and that’s that.
Sometimes, however, we can exercise some control over the tax burden on our investments. A great example is Opportunity Zones, one of the big innovations from the Tax Cuts & Jobs Act of 2017.
What are the Zones?
Opportunity Zones are meant to encourage development in economically challenged communities. They are specific geographic areas that offer tax incentives for investments made within their borders –provided those investments somehow improve the land or business in that area.
Here, for example, are the Opportunity Zones in the Pacific Northwest:
If you squint, you will notice that most urban areas have multiple tiny OZs clustered together – a pattern that repeats across the country. So chances are good you at least have one within easy driving distance, unless you really live in the middle of nowhere.
What is the Opportunity?
The IRS encourages investment in OZs by offering a reduction on the capital gains tax that normally applies to the proceeds you earn from selling invested assets. That reduction can shake out in several ways:
- Deferral of tax on existing capital gains – When you sell an investment for a gain, you must pay capital gains taxes on the profit. But if you reinvest those profits in an OZ within 180 days, you can defer paying that tax until one of the following happens:
- You file your 2026 taxes; or
- You move those assets/cash out of the OZ.
(In addition, the deferred gain can be further reduced as described below):
- Reduction of taxable capital gains – After you’ve been invested in an OZ for 5 years, any capital gains on which you are already deferring tax (per Option 1) will get a 10% “step-up in basis” – that is, the taxable amount will be reduced by 10%.
- NOTE: If you were already invested in an OZ by 12/31/19, and stick with it until 2026, you get a 15% reduction.
- No tax on new capital gains – Once you’ve been invested in an OZ for 10 years, you will no longer owe capital gains tax on your earnings from that investment.
What’s the Catch?
Remember, a tax break on your investment only helps if the investment itself is good to begin with. The IRS also knows this, and specifies that merely throwing money into land, buildings, or businesses in an OZ is not enough to qualify for the benefits outlined above.
Rather, you must make “substantial improvements” to the land, building, or business in question – i.e., doubling the value of your investment within 30 months. If you purchased property in an OZ for $400,000, for example, you must also improve that property by another $400,000 within 30 months.
Sounds like a lot of work and commitment, I know; but that is true of most good investments. So if you are going to put in that effort anyway, why not go for a nice tax break while you’re at it?
More info about OZ’s and where to find them at https://www.cdfifund.gov/opportunity-zones