Several months back, I identified two neighborhoods I would consider as good real estate investment locations. Over the intervening period, the Opportunity Zone program of the 2017 tax reform package (Tax Cuts and Jobs Act) has come in to focus, making one of the areas I suggested – Englewood (here) – an even more attractive neighborhood for anyone who wants to roll out of a prior investment, but is wary of the capital gain implications.
The Opportunity Zone program (primer) provides tax incentives for investment (both in real estate and in businesses) in low income urban and rural areas. Colorado has designated Opportunity Zones (map), offering the opportunity to leverage an investment in these areas for even greater after tax gains. The tax incentives include:
- Temporary deferral of capital gain tax from your original sale, possibly until 2026.
- Stepped up basis for the gains reinvested investments held 5 or 7 years
- Permanent exclusion from capital gain tax on investments held for 10+ years
The net result is that you can unlock past gains and create an opportunity for tax free gain in the future.
Here is a simple scenario:
- Sell a investment property or business, recognizing a capital gain.
- Invest that gain in an “Opportunity Fund” – this is a specially created corporation or partnership whose goal is to deploy its capital in Opportunity Zone areas (rules apply). Large-scale Opportunity Funds are available, but the bar to self-certify an LLC or Partnership as an Opportunity Fund appears to be fairly low (fill out a form and self-certify) allowing investors to create their own funds. The Opportunity Fund can then undertake direct investment in real estate (like an income-generating property or re-development opportunity), investment in new business formation or investment in an existing business.
- Enjoy a temporary deferral on the capital gain tax from your $100,000 gain until 2026 or until you sell your Opportunity Fund investment, if earlier.
- Recognize income from your Opportunity Fund investment over time.
- If you hold the Opportunity Fund investment for at least 5 years, your basis on your original gain is increased by 5%. If you hold it for 7+ years, your basis is increased by a total of 15%, lowering the amount of tax you will pay on the original gain.
- If you hold your Opportunity Fund investment for 10+ years, gain on the Opportunity Fund investment is excluded from taxation!
The rules on all of this are just starting to come into focus (IRS-FAQ). One of the critical rules which is still not totally clear is how depreciation recapture – both on the original liquidation and the subsequent Opportunity Fund liquidation is treated, which could have big implication on the feasibility of exercising this opportunity for many investors.
But in the interim, check out the Opportunity Zones throughout Colorado (map) to see where you might find some interesting opportunities. Several of the urban areas in the Denver Metro (West Colfax, East Colfax, Cole, Arvada, Sunnyside) have already favorable underlying fundamentals plus there are several mountain locations (Avon, Estes Park, Buena Vista, Glenwood Springs, Pagosa Springs, Idaho Springs) of interest as well, all of which might allow for a significant gain in your Opportunity Fund investment, which, if held for 10+ years, you’d pay no tax on!