Long-term capital gains receive a benefit of being taxed at a lower tax bracket than ordinary income. However, a tax planning strategy used by taxpayers to increase this benefit is to defer the taxability of that gain to a future year.
The Tax Reform Act provided a program to defer capital gains called Opportunity Zone Investing. Through this program, a taxpayer can defer capital gains on the sale of an asset by investing those gains through a Qualified Opportunity Fund. Similar to other tax deferral programs such as the like-kind exchange regulations, there are reinvestment dates that must be adhered to. With the Opportunity Zone investment, the gain proceeds must be reinvested into a designated Opportunity Zone (OZ) within 180 days of the gain transaction.
There are three layers of benefits under this program.
- The first layer is a 10% reduction on the amount of the deferred capital gain if the investment is held in place for 5 years.
- The second layer is an additional 5% reduction in the amount of the deferred capital gain if the investment is held in place for an additional two years. The pitfall under the current regulations is that the deferral expires on December 31, 2026 and if the investment had not been held for the 5 or 7-year threshold as of that date, the taxpayer might not receive the reduction in the referral capital gain. This means either 85%, 90% or the whole deferred capital gain will be taxable. In order to meet the 7-year holding period, the capital gain reinvestment would need to be reinvested by December 31, 2019 (this year), meaning the 5% reduction would not occur.
- The last layer is the area that is most beneficial to the taxpayer. If the investment is held for at least 10 years, any capital gain on that investment is not taxable.
Here is a simplified example showing the benefits of the Opportunity Zone investment.
- March 31, 2019 – Sale of stock resulting in a $10,000 long-term capital gain.
- By September 27, 2019 – The $10,000 is reinvested into an OZ.
- September 27, 2024 (5 years) – The deferred long-term capital gain is reduced by 10% to $9,000.
- September 27, 2026 (7 years) – The deferred long-term capital gain is reduced an additional 5% to $8,500.
- December 31, 2026 – The taxpayer is required to pay tax on the $8,500 deferred long-term capital gain.
- On or after September 27, 2029 – The taxpayer sells the OZ investment for $50,000 and would pay no tax on that transaction that would have resulted in a $40,000 long-term capital gain.
As you can see in this simple example, the biggest benefit is the third layer. This benefit assumes that the investment appreciates in value. There is value in the other two layers whereby the payment of the tax on the sale of stock was deferred for over 7 years as well as reduced by 15%.
The program is new and there are a number of items that the Internal Revenue Service is currently reviewing and has promised to provide guidance on shortly. If you have a recently generated capital gains, please contact SVA to see whether the Opportunity Zone investment could benefit you.