If you’ve incurred capital gains in 2021, you should be taking a hard look at whether to invest those gains in an Opportunity Zone Fund. With tax reform and a potential increase in the capital gains tax looming, the Opportunity Zone program may offer potential relief to taxpayers, especially those with capital gains incurred after September 13. Dec. 31, 2021 is your last chance to take advantage of one of the program’s unique tax savings mechanisms. Ohio also renewed its Opportunity Zone program in 2021, making the investment potentially even more beneficial.
Opportunity Zones Create Tax Benefits for QOZ Investors
Created by the 2017 Tax Cuts and Jobs Act (TCJA), the Opportunity Zone program provides three distinct tax benefits to those who invest in Qualified Opportunity Zones (QOZs):
- Recognition of capital gains that are reinvested in a Qualified Opportunity Fund (QOF) are deferred until Dec. 31, 2026
- The amount of those deferred capital gains is reduced via an increase in basis – a 10% step up five years after investment and an additional 5% at year seven
- Appreciation of the QOF investment is exempt from taxation so long as certain requirements are met
Unless Congress changes the program rules, 2021 is the last opportunity to take advantage of the 10% step up in basis.
Let’s look at an example for a taxpayer who has $10M in capital gains, realized after Sept. 13, 2021. In these examples, we assume that the Democratic Tax Proposal passes by year end, increasing the capital gains rate to 25% on any gains incurred after Sept. 13, 2021. For simplicity’s sake, this example assumes that the taxpayer who didn’t invest in the QOF holds in an investment for 10 years even though not required to.
TAX BURDEN FOR $10M IN CAPITAL GAINS (Assumes Democratic Tax Proposal Passes)
| Invested in QOF | Not Invested in QOF | |
| 2021 | $0 | $2,500,000 |
| 2026 | $2,250,000 | $0 |
| Sale in 2031-2048 assuming 2x Value in 10+ years | $0 | $2.5M |
| Total Tax: | $2,250,000 | $5,000,000 |
By investing in a QOF, the taxpayer would save nearly $2,750,000 in federal taxes. If the Republicans take back the House and Senate before the 2026 capital gains recognition deadline and reduce the capital gains rate back to 20%, the taxpayer saves an additional $X.
TAX BURDEN FOR $10M IN CAPITAL GAINS (Assumes Democratic Tax Proposal Passes but Republicans Return Cap Gains Rate to 25% Before 2026)
| Invested in QOF | Not Invested in QOF | |
| 2021 | $0 | $2,500,000 |
| 2026 | $2,000,000 | $0 |
| Sale in 2031-2048 assuming 2x Value in 10+ years | $0 | $2M |
| Total Tax: | $2,000,000 | $4,500,000 |
Opportunity Zone Regulations
The opportunity for significant tax savings also comes with some regulatory hurdles. Opportunity Zone Funds are regulated by the IRS and include several requirements, the most significant of which are:
- The Qualified Opportunity Fund must be a partnership and organized with a specific purpose
- All investments in the QOF must be in the form of equity
- At least 90% of the Fund’s assets must be invested in QOZ Property
The investments in the QOZ Property are subject to further restriction, depending on whether it is QOZ Stock, QOZ Partnership Interests or a QOZ Business.
If you have questions about forming or investing in an Opportunity Zone Fund, KJK’s corporate and tax attorneys can help. You can reach out to Jon Pinney at jjp@kjk.com or 216.736.7260 or Jennifer Hart at jmh@kjk.com or 216.310.4917 with questions about the program or structuring an investment.