This is the Appendix to The Ultimate Guide to Opportunity Zone Investing
Taking advantage of opportunity zone investing can save a taxpayer thousands or even millions of dollars on his tax bill. Using our opportunity fund tax calculator, it’s easy to see how powerful the incentive is to invest in opportunity zones.
Note: The U.S. Treasury department has not yet finalized its guidelines on capital gains invested in opportunity zones. As such, it is still unclear how certain provisions of the existing legislation would apply, particularly when it comes to the timing of 5-year, 7-year, and 10-year milestones, and how they pertain to stepping up basis on the original investment.
To demonstrate the potential for tax savings, let’s look at a few different hypothetical examples.
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Example #1: $100,000 capital gain invested in opportunity fund doubles in value after 10-year holding period
In our first example, assume that The Investor realizes a $100,000 capital gain on his original investment. This could be from sale of any asset (stock, mutual fund, real estate). It doesn’t matter where the gain came from.
On December 31, 2018, The Investor invests the $100,000 capital gain in a qualified opportunity fund. Note: this investment must occur within 180 days of the cap gains realization. By April 15, 2019, The Investor simply needs to make an election on his tax filing, showing that this $100,000 capital gain has been rolled over into an opportunity fund. So long as The Investor does not sell or exchange his share in the opportunity fund, his original $100,000 gain is tax deferred until December 31, 2026.
In the meantime, his basis in the original investment effectively “steps up” twice. The first step-up in basis is 10 percent on the 5-year anniversary of the opportunity fund investment. In this example, this occurs on December 31, 2023.
The second step-up in basis is an additional 5 percent (bringing the total step-up in basis to 15 percent) on the 7-year anniversary. In this example, this occurs on December 31, 2025. Remember, the tax on the original $100,000 gain was deferred until December 31, 2026. Therefore, on April 15, 2027, The Investor finally owes capital gains tax on the original gain. But because he has received the full 15 percent step-up in basis from the original investment, instead of paying capital gains tax on the full $100,000 amount, he is now only obligated to pay capital gains tax on $85,000.
Assuming a capital gains tax rate of 20%, The Investor would have a tax bill of $17,000 due on April 15, 2027. Without the opportunity fund investment, The Investor would otherwise have owed $20,000 in capital gains tax on April 15, 2019.
Furthermore, let’s assume that after a 10-year holding period, the investment in the opportunity fund has doubled. The Investor’s $100,000 share in the opportunity fund is worth $200,000 when he sells it on December 31, 2028. Having held the opportunity fund for at least 10 years, The Investor is now able to waive his entire gain for tax purposes. He owes 0 on the subsequent $100,000 gain.
In this example, The Investor effectively paid only $17,000 in capital gains tax on $200,000 in total gains. Without the opportunity zones tax rules, an investor would normally owe $40,000 in taxes on $200,000 in capital gains (assuming a 20% rate). Thus, The Investor has saved $23,000 in taxes.
Example #2: $100,000 capital gain invested in opportunity fund doubles in value after 8-year holding period
In our first example, The Investor took full advantage of the opportunity zones tax regulations by holding his opportunity fund for a full 10 years. This allowed him to pay no tax on his subsequent $100,000 gain.
In our second example, let’s make all of the same assumptions, except change The Investor’s holding period from 10 years to 8 years. The Investor now sells his share in the opportunity fund on December 31, 2026 for $200,000.
The Investor still receives the 15 percent step-up in basis on the original investment and pays $17,000 in capital gains tax on April 15, 2027. However, since The Investor did not hold his opportunity zone investment for the full 10 years, he owes tax on any gain in the fund. In our example, this is a subsequent gain of $100,000. Therefore, The Investor would owe an additional $20,000 in capital gains tax on April 15, 2027, for a total amount owed of $37,000. His savings from the opportunity zone investment is just $3,000, instead of the $23,000 in savings from the first example.
Example #3: $100,000 capital gain invested in opportunity loses value
Read about hypothetical opportunity fund investments just about anywhere, and they’ll all assume a gain on the opportunity fund investment. But investments do actually lose value sometimes! Let’s assume that in our final example.
The Investor has a gain of $100,000 from his original investment. Within 180 days, he invests this $100,000 in an opportunity fund. He holds the fund for 7 years, so he receives the 15 percent step-up in basis on his original investment before his deferred tax on the gains are due on April 15, 2027. He owes $17,000 on this date.
After a 10-year holding period (say, December 31, 2028), The Investor sells his opportunity fund share for $50,000, thereby realizing a loss of $50,000. He would owe no tax and in fact can use this loss against his income for 2028.