2021 Set to be Biggest Year Yet for Opportunity Zones

Stone Pigman associate Sanders Colbert was recently featured in New Orleans CityBusiness discussing the three major tax breaks provided by the Opportunity Zone Program and why 2021 is likely to be the biggest year yet for these investments.

A perfect storm of rising stock portfolios and sun-setting tax provisions have set the stage for 2021 to become the biggest year yet for opportunity zones investments.  The program, introduced as part of the 2017 tax reform act, provides several tax incentives intended to encourage investments in designated low-income areas.  Potential investors seeking to maximize the program's remaining tax benefits should be aware of several critical upcoming dates before the end of the year.

The program provides three major tax breaks for investors who rollover eligible capital gains into Qualified Opportunity Funds (QOFs), which are self-certified corporations or partnerships formed for the purpose of purchasing property and investing capital within opportunity zones.  In the short term, investors with directly recognized capital gain can defer paying taxes until December 31, 2026 if they reinvest the amount of the gain in a QOF within 180 days of the recognition date and maintain the investment until 2027.  Investors recognizing capital gain through pass-through entities are considered to have recognized the gain on the date the entity's return was due, and individuals with capital gains reported on a 2020 K-1 have until September 11, 2021 to reinvest the same amount in a QOF to defer paying taxes.  Money used to fund eligible QOF investments can come from any source and does not have to be traceable to cash received when the gain was initially recognized.  The tax due when the deferred gains become taxable at the end of 2026 will be based on whatever tax rates are five years from now; however, the amount of deferred gain reported as income at that time will be reduced by 10% as long as the QOF investment is made by December 31, 2021. 

Although the prospect of deferring taxes until 2026 may seem like a bargain, the greatest tax benefits go to new investors willing to wait a few years longer to receive complete tax-free treatment.  Taxpayers who stay in a QOF for at least ten years will receive a full stepped-up basis on the date they dispose of their investment and recognize no capital gain on any additional appreciation that has occurred over that period.  This final tax break makes the program especially lucrative for real-estate based QOFs, which if structured properly can potentially provide investors with up-front building depreciation deductions without resulting in additional capital gain when the taxpayer exits after ten years.  Downtown New Orleans is particularly suited for real-estate investments given that substantial areas of the Central Business District are located within opportunity zones, and local investors should consider forming a QOF themselves when acquiring property in areas covered by the program.

Interestingly, only the portion of a QOF investment attributable to eligible capital gain at the time the initial investment is made receives this tax-free treatment after ten years, essentially providing an extra tax-benefit to investors who defer paying capital gains taxes compared to investors who do not owe any capital gain taxes in the first place.  As a result, the rise in stock market valuations over the past year makes opportunity zones potentially attractive at the moment even for taxpayers without existing capital gains to defer.  Investors seeking to take advantage of the program may consider deliberately liquidating appreciated securities to reinvest in QOFs before the end of the year so that any deferred capital gain additionally qualifies for the 10% reduction at the end of 2026.  While it would not normally make sense to create a tax liability just to defer it, the additional tax-free treatment on capital gains reinvested for ten years could result in even greater long term tax savings depending on the amount of appreciation in the fund's assets by the time the taxpayer cashes out.  Partners in a partnership, shareholders of S corporations, and beneficiaries of estates and trusts should additionally be aware of the September 11, 2021 deadline to reinvest and defer eligible capital gains issued on a 2020 K-1.