Last Updated February 15, 2020
Are you looking for some new investment opportunities that have great tax advantages? You may want to consider investing in an Opportunity Zone Fund. But what is an Opportunity Zone Fund and how does it work? This article will break down some of the details so you can decide if it’s a good investment opportunity for you.
What Is An Opportunity Zone?
According to the IRS, an Opportunity Zone is an economically-distressed community where new investments may be eligible for tax breaks. Opportunity Zones were created by Congress in the Tax Cuts and Jobs Act of 2017. These areas are nominated by governors and certified by the U.S. Department of Treasury.
If you are interested in knowing where the Opportunity Zones are located, you can find the list of Opportunity Zones available HERE. They are still working on making a visual map of the census tracts designated as Qualified Opportunity Zones.
What Is The Purpose Of Creating An Opportunity Zone?
Opportunity Zones were created to allow investors to invest in new projects. This is to stimulate economic development in exchange for certain federal tax benefits.
According to the Department of Treasury, the median family incomes of Americans living in designated Opportunity Zone area are 37% below the area or state median. On average, those areas have an unemployment rate almost 1.6 times higher than the national average. Therefore, the purpose of the program is to promote long-term economic development and job creation in these areas.
What Is An Opportunity Zone Fund?
An Opportunity Zone Fund is set up either as a partnership or corporation, for investing in eligible property that is located in an Opportunity Zone. The U.S. partnership or corporation should intend to invest at least 90% of its holdings in one or more qualified Opportunity Zones.
Investors must invest specifically through an Opportunity Zone Fund in order to access the tax benefits of the Opportunity Zone Program.
How Does The Opportunity Zone Program Work?
People must invest their capital gains in a Opportunity Zone Fund. Capital gains are the profit from the sale of property or an investment. In exchange for their investment, investors will get a tax benefit.
The Opportunity Zone Program provides three tax benefits for investors to re-invest their unrealized capital gains into Opportunity Zone Funds. An unrealized capital gain is capital gains that only exist on paper and has yet to be sold in return for cash.
The three incentives offered by the Opportunity Zone Program are:
Temporarily Defer Capital Gain Taxes
Once you sell an investment for profit, you normally have to pay taxes on those capital gains. Under the Opportunity Zone Program, you can defer paying taxes on those capital gain profits until December 31, 2026.
So for example, assume you invested $10,000 in stocks a few years ago. Today, the value of your stocks is $30,000. If you sold your stocks, you would normally have to pay taxes on that $20,000 profit.
Under the Opportunity Zone Program, if you reinvest your $20,000 into a Opportunity Zone Fund, you can defer the taxes you would have to pay on that $20,000 until 2026.
Reduce Capital Gain Taxes Owed
The next tax incentive is, if an investor holds their investment in an Opportunity Zone Fund for at least 5 years, then the tax on the initially deferred gain will get a 10% tax cut. If the investment is held for at least 7 years, they will get an additional %5 tax cut, making it a total of 15% tax cut on those initially deferred gains.
That may sound a little complicated, so let me break it down for you with an example:
Going back to my previous example where you invested $10,000 in stocks, and today your stocks are worth $30,000. If you invest your $20,000 gains in an Opportunity Zone Fund, and hold your shares for at least 5 years, you will only have to pay taxes on $18,000 (instead of $20,000). If you hold your shares for at least 7 years, you will only have to pay taxes on $17,000.
No Taxes On Any Capital Gains From Investment In Opportunity Zone Fund
The final tax incentive is, if you hold your investment in an Opportunity Zone Fund for at least 10 years, you don’t have to pay any federal capital gains tax on the profits from that fund.
Let me give you an example. Let’s say the $20,000 you invested in an Opportunity Zone Fund grew to $60,000 after 10 years. If you decide to sell your shares, you do not have to pay any taxes on that $40,000 profit.
Putting It Altogether
Let me give you a few examples where I put these tax incentives altogether. Assume the following facts for each example:
You invested $10,000 in stocks a few years ago. Over time, the value of your stocks grew to $30,000. You sell your stocks and have a capital gain of $20,000. You roll over your $20,000 and invest in a Opportunity Zone Fund. The $20,000 you invested in your Opportunity Zone Fund grew to $60,000 at the time you’re ready to sell.
Example #1: Investor Holds Shares In Opportunity Zone Fund For 5 Years
You can defer the taxes you would have to pay on the $20,000 of capital gains until 2026. When your capital gains taxes come due, you will only have to pay taxes on $18,000 (instead of $20,000)—10% tax cut. Finally, you will owe capital gains tax on the $40,000 appreciation of your Opportunity Zone Fund, since you held your investment for less than 10 years.
Example #2: Investor Holds Shares In Opportunity Zone Fund For 7 Years
You can defer the taxes you would have to pay on the $20,000 of capital gains until 2026. When your capital gains taxes come due, you will only have to pay taxes on $17,000 (instead of $20,000)—15% tax cut. Finally, you will owe capital gains tax on the $40,000 appreciation of your Opportunity Zone Fund, since you held your investment for less than 10 years.
Example #3: Investor Holds Shares In Opportunity Zone Fund For 10 Years
You can defer the taxes you would have to pay on the $20,000 of capital gains until 2026. When your capital gains taxes come due, you will only have to pay taxes on $17,000 (instead of $20,000)—15% tax cut. Finally, you will not owe any capital gains tax on the $40,000 appreciation of your Opportunity Zone Fund, since you held your investment for 10 years.
Think Long-Term And Keep Risk In Mind
As you can see from my examples above, you get the most tax benefits if you hold your investment for at least 10 years. Although I think this can be a great program for investors, you shouldn’t skip your due diligence. Approach these funds the same way you would any investment option.
Also, remember this is a federal tax break, so be mindful of state tax consequences. Not all states may follow the federal taxation rules for Opportunity Funds.
Finally, consider how Opportunity Zones fit into your overall portfolio and your investment timeframe. To get the full tax benefits, you need to invest in Opportunity Zone Funds for at least 10 years. Therefore, it is important to consider whether you will need this money in less than 10 years before you decide to invest.
If you’re new to investing, you can read my article “Ways To Invest For Beginners: Investing 101.”
An Opportunity Zone Fund can be an excellent new investment to add to your portfolio. It offers many tax incentives that allow you to: 1) defer paying taxes until 2026; 2) reduce capital gain taxes owed; and 3) forgive any capital gains taxes from your Opportunity Zone Fund. If you decide to invest in one of these funds, make sure to think long term and do your research first.
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