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Finding opportunity in the zone


image of coins with rising arrow on chartWhen you are “in the zone,” you are hyper-focused and at peak performance.

For investors, “the zone” means owning an optimal mix of investments with your desired risk and return profile. That zone is better when an investor takes advantage of lucrative new federal tax benefits while creating jobs and injecting life into struggling urban or rural areas.

Qualified Opportunity Zones (“QOZ”) were created by the federal Tax Cuts and Jobs Act of 2017 to incentivize long-term investment in low-income communities.

Complex changes to a section of the Internal Revenue Code signed Dec. 22, 2017, created a special rule for the reinvestment of long-term capital gains into QOZ Funds, QOZ Property or QOZ Businesses.

If you currently hold appreciated capital gain property, you can sell it to realize your gain. If you reinvest that gain into one of these three investments, you do not recognize the gain currently.

How it works

For example, assume you paid $400,000 for stock, more than a year ago, that is now worth $1 million. If you sell it, you would realize a $600,000 gain, and the tax on that gain is likely to be $120,000 (20 percent highest long-term capital gains tax rate). Thus, you would have $1 million minus $120,000 — or $880,000 — left to reinvest or spend.

But now there’s a way to still hold onto the full $1 million.

If you invest at least $600,000 in one of the three QOZ investments, within 180 days of the sale, you can defer recognizing the gain in the year of sale. You can also invest the other $400,000 here or elsewhere. Because you paid no tax on the gain, your adjusted basis (or cost) in the investment is zero. If you remain invested for five years, the adjusted basis of your investment increases to $60,000, or 10 percent, without paying any tax. Stay for two more years –seven years– and your basis is increased again by another $30,000 (5 percent) to $90,000 (15 percent). If you divested at that point, you recognize the $600,000 gain reduced by the $90,000 of adjusted basis. That way, you would only pay tax on $510,000 of gain when you divested, (depending upon the value of your interest). You must recognize the remaining gain ($510,000) and pay the 20 percent Long-term Capital Gain Tax of $102,000 in your 2026 income tax return. It is essential to have adequate liquidity at that time to pay the tax.

But the deal gets better. If you stay invested for 10 years, assume the fair market value of your investment has grown to $1,712,000 (a 10 percent reinvested growth). The law allows you to adjust your basis in the investment to the fair market value on the date of sale – the full $1,712,000. If you sell the investment for $1,712,000 – your adjusted basis of $1,712,000, the gain you recognize is zero.

So, not only did you save 15 percent of the tax on your original $600,000 gain, but you saved the tax on the appreciation — equaling another $1,112,000 of gain. That’s another $222,400 at 20 percent, on top of the $18,000 you already saved –representing a total tax savings of $240,400. Note that if you did invest the additional $400,000, that investment is tracked separately, and does not enjoy the step-up to fair market value benefit.

A benefit for your heirs as well

Marry that substantial savings on long-term capital gains tax with changes in the gift, generation skipping (“GST”) and estate tax systems from the 2017 tax changes.

You can pass that savings on to your heirs, by using the increased unified credit of the gift, GST and estate tax systems. For 2019, the exemption amount associated with the unified credit is $11.4 million for each spouse.

Baby Boomers should be delighted to be able to harvest long-term gains while markets and valuations are up, pay reduced long-term capital gains tax, and pass on that value, up to the limit, to the next generations.

Moving forward

Of course, you should evaluate these three types of investments for their level of risk and level of return earned as part of your overall investment portfolio. To be an eligible QOZ investment, the investment must be in a fund that owns qualified QOZ property or businesses, or in the actual property or business in the QOZ.

Governor Wolf was quick to nominate opportunity zones after the law’s enactment, in these areas:

As the regulations on this tax break unfold, Boyer & Ritter LLC can help advise you on how to invest in lower income communities while growing your assets.

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