A New Way to Defer and Partially Eliminate Capital Gains Taxes

By MICHAEL EDLEN | Special to the Palisadian-Post

The Tax Cuts and Jobs Act that Congress passed in December 2017 included new sections in the tax laws that established a community development program called Opportunity Zones (OZ). The idea was to encourage long-term investments in low-income and distressed communities nationwide.

The essence of the program is to reward reinvestment of profits into an OZ, which are low-income census tracts selected by state governors and certified by the U.S. Treasury Department. There are more than 8,000 such zones, including nearly 900 in California, providing real estate investors with the opportunity to defer or even eliminate capital gains taxes while also spurring economic development and job creation.

The OZ program requires that investors reinvest capital gains funds through a Qualified Opportunity Fund (QOF) within 180 days after the sale of a capital asset and that the investment is held for a minimum of five years. If the investor holds for more than 10 years, the investor will also benefit by not having any capital gains tax on the appreciation of that asset, in addition to having a partially stepped-up basis in their original gain that was deferred.

There are specific requirements for the QOF and they may acquire property in a few different ways. The Treasury Department and the Internal Revenue Service are still working out further details and legal guidance on this new tax benefit, and detailed information is available at treasury.gov and IRS.gov.

Investors must check with their tax consultants for up-to-date particulars about this new program and how they may benefit from its provisions. It is our understanding this program also has some benefits as compared with 1031 Tax-Deferred Exchanges.

For example, OZ investments allow for more flexible and creative use of capital. With a 1031 Exchange, the initial investment is locked in along with the capital gains accrued over the life of the investment.

Whenever another asset is purchased, all of the investment rolls over into that new asset. Most investors hold on to their real estate until they pass on, which enables their heirs to get a step-up in basis and thus minimize taxes the family will ultimately pay.

With OZ, investors don’t have to die to eliminate the capital gains burden. After 10 years, the entire basis automatically steps up.

It is our understanding that this will also include saving taxes on any depreciation of the asset, as compared with the 1031 where investors may have to pay for “depreciation recapture.” Again, investors must consult their own tax experts about the details and how such a program can be used to their best benefit.

Some money managers and developers consider this new program the biggest thing that’s ever happened in real estate in this country. With an estimated $6 trillion of unrealized capital gains by U.S. households and corporations that could be eligible for reinvestment in OZ, affordable housing programs specifically designed for the communities that most need them will be enabled.

Moreover, the tax breaks increase the potential for long-term profits, which, in turn, may encourage lenders to back projects that might not have otherwise been considered financially safe.

Of course, new construction will be encouraged by the biggest tax breaks going to investors who keep their money in these zones for at least 10 years, and thus the whole economy is likely to benefit from significantly greater construction nationwide, while also helping to fund the neediest communities through social impact investments.

Real estate lawyers and advisory firms are rapidly setting up programs to assist developers in accessing the huge potential of new investor money, while many QOFs are being created to meet the evolving guidelines and rules.

In theory, the new program may also enable many long-time homeowners to feel freer to sell their homes not have to pay huge taxes by deploying the money into OZ holdings, which, in turn, may have tax-deferred or tax-free capital growth.

Please confer with tax experts!

Michael Edlen has counseled more than 2,000 local homeowners and is always available to discuss strategies to maximize home values and owner’s objectives. He can be reached at 310-230-7373 or michael@edlenteam.com.