The Tax Cuts and Jobs Act1 , passed by Congress in the closing days of 2017, introduced transformative changes to the U.S. economy, including the creation of a new investment model with unprecedented tax incentives for capital gains: Qualified Opportunity Zones and Opportunity Funds.
Opportunity Funds promote investment in the development of low-income communities across the US, by offering investors federal tax advantages that are only available through the new Opportunity Zone program. When investors put their money to work in qualified Opportunity Zones through a qualified Opportunity Fund, they can defer and reduce their capital gains tax burden thanks to provisions outlined by the 2017 law.
In fact, investors can defer and reduce realized capital gains on the principal invested, and even eliminate their capital gains tax burden on returns earned through the sale of investments in qualified Opportunity Zones. While some tax incentives are available to Opportunity Fund investors immediately, in general, the greatest number and extent of tax incentives are available to long-term investors.
But what are the exact tax incentives of Opportunity Funds, and how do they work?
First, to understand the benefits of Opportunity Funds, it’s important to understand what an Opportunity Zone is.
Opportunity Zones are census tracts of low-income areas designated by state governors (or, in the case of Washington, D.C., the mayor) and certified by the U.S. Department of the Treasury. These areas are being targeted for economic development through the newly created Opportunity Zone program. Investors can invest in the development of qualified Opportunity Zones through Opportunity Funds, which can then give them significant federal capital gains tax advantages, both immediately and over the long term.
What is an Opportunity Fund and what are the tax incentives that it offers?
An Opportunity Fund is an investment vehicle that intends to invest at least 90% of its holdings into partnership interests, businesses, or property (real estate, factory equipment, etc.) within a qualified Opportunity Zone. Opportunity Funds are required to invest in ways designed to improve the Opportunity Zone’s community, such as supporting a local business or sparking the rehabilitation of local buildings.
In exchange for investing in economically distressed areas, Opportunity Funds offer investors several capital gains tax incentives, which offer ways both to preserve investment dollars now and keep more of the investment return later.
When an investor sells an appreciated asset, such as stocks or real estate, they realize a capital gain, which typically triggers a tax event. However, if that investor reinvests their realized capital gain into an Opportunity Fund, they can expect to minimize their tax burden substantially.
Here’s a breakdown of the tax advantages of Opportunity Funds:
- By moving realized capital gains into a qualified Opportunity Fund within 180 days of the asset sale, investors can defer paying capital gains taxes on that gain until December 31, 2026 or until they sell their Opportunity Fund investment – whichever is earlier. Deferring their tax liability allows investors to put a greater amount of capital to work for a longer period of time. Funds that otherwise would have been used to pay taxes upfront can instead be invested and earn returns for several additional years. In other words, the ability to defer capital gains tax gives Opportunity Fund investors a major advantage in the earning power of their dollars.
- If an investor holds their Opportunity Fund investment for at least 5 years prior to December 31, 2026, they can reduce their deferred capital gains tax liability by 10% through a step-up in basis. If that investor holds their Opportunity Fund investment for 2 additional years they can reduce their deferred capital gains liability by another 5%. That means by holding an Opportunity Fund investment for 7 years prior to December 31, 2026, an investor can reduce their tax liability on the deferred capital gains invested in the Opportunity Fund by 15%.
- If an investor holds their Opportunity Fund investment for another 3 years (10 years total), they can expect to pay zero dollars in capital gains taxes on any appreciation from their original Opportunity Fund investment. That’s because Opportunity Fund gains earned from Opportunity Zone investments can qualify for permanent exclusion from the capital gains tax if the investment is held for at least 10 years.
So, in summary, if you’re able to reinvest realized capital gains into an Opportunity Fund, you stand to benefit from steadily improving tax incentives the longer you hold the investment — with the key tax incentives available at 5, 7, and 10 years.
To put this into visual terms, here’s a timeline of what investors could expect under an Opportunity Fund:
Illustrative Scenario: After-Tax Potential Net Returns
An Example of an Opportunity Fund Investment
To illustrate the value that an Opportunity Fund can offer a long-term investor, consider the differences between an Opportunity Fund investment and a traditional stock portfolio:
|Traditional Stock Portfolio||Opportunity Fund|
|2016||John purchases an investment for $500,000.||John purchases an investment for $500,000.|
|2018||John sells the investment for $600,000, and realizes long-term capital gains of $100,000.||John sells the investment for $600,000, and realizes long-term capital gains of $100,000.|
|December 31, 2018||John invests his capital gains in a traditional stock portfolio. Assuming a typical tax rate of 23.8%, he pays a capital gains tax of $23,800.||John invests his capital gains in a qualified Opportunity Fund. He defers his capital gains taxes, so he pays nothing for 7 years.|
|2019-2028||John earns a 7% average annual return on his investment.||John earns a 7% average annual return on his investment.|
|2026||—||John now recognizes the deferred capital gain that was triggered in 2018, but his tax liability is reduced by 15% due to the Opportunity Fund program. He now pays $20,230 in capital gains tax instead of $23,800.|
|2028||John sells his investment after realizing a 7% average annual return over its lifetime. He pays an additional capital gains tax of $14,343.||John sells his investment after realizing a 7% average annual return over its lifetime. He pays no capital gains tax on this sale.|
If John is a long-term investor who intends to reinvest his gain for at least 10 years, he can potentially double his after-tax return by reinvesting those capital gains into a qualified Opportunity Fund instead of following the traditional investment path, assuming all else being equal.
It’s worth noting that, in the above hypothetical scenarios, we assume that traditional investments and qualified Opportunity Funds will perform similarly over time, earning comparable returns. While it’s not possible to predict future returns, we are optimistic about the ability of Opportunity Funds to realize particularly attractive returns, as we believe the tax incentives offered through the Opportunity Zone program may help initiate a virtuous cycle in certain markets, as a multitude of investors concurrently seek to invest in these areas.
Thanks to the wide range of investment options that qualify for investment under the Opportunity Zone program, we anticipate broad-based growth in particular Opportunity Zones, as well as the ability to leverage our expertise using investment strategies similar to those we have pursued in the past. In fact, many of our most notable investment projects to date have been in neighborhoods that are now designated as qualified Opportunity Zones.
An Example of an Opportunity Fund Investment
Putting it All Together
Thanks to the exclusive set of capital gains tax incentives available only under the Opportunity Zone program, Opportunity Funds offer great potential for long-term investors to earn significantly better returns than they would following a traditional investment path. The Opportunity Fund offers an easy, hands-off way to get started. Our Opportunity Fund intends to focus on investing in high-quality real estate in major US cities with long-term growth potential.
Are you curious what your after-tax returns might look like if you invest in an Opportunity Fund?