A Chance to Unlock Unrealized Capital Gains and Invest Where It’s Needed
You may have heard the term “Opportunity Zones” and wondered what that means for property investors. Opportunity Zones are designed to drive investment money to certain geographic areas — and they offer investors significant tax benefits for doing so.
Here in Winston-Salem, thanks in no small part to the hard work of Mayor Allen Joines and his staff, Governor Cooper has designated 10 Census Tracts as Opportunity Zones. These Opportunity Zones were designated under authority provided through the passage of The Tax Cuts and Jobs Act (H.R.1) earlier this year. H.R.1 places a new, robust tool in the toolbox of investors in the form of Internal Revenue Code Section 1400Z-2. If certain rules are followed, the provision will delay recognition of capital gains and reduce them upon recognition.
Ideally, what this could mean for these designated areas is an influx of much-needed capital to revitalize a struggling neighborhood. For investors, it provides a way to invest with attractive tax incentives.
Until the passage of The Tax Cuts and Jobs Act earlier this year, Internal Revenue Code Section 1031 has been the way for owners of investment property to delay recognizing capital gains on the sale of their properties. Boiled down to its most basic summary, in a 1031 exchange (or a “like kind” exchange), an owner of investment property can avoid paying capital gains tax on the sale of that property as long as it reinvests the money from that sale in a property or properties of “like kind,” and of equal or greater value within a certain timeframe.
While 1031 exchanges certainly aren’t going anywhere, Section 1400Z-2 promises to do what Section 1031 does and more.
How Opportunity Zones Work
First, the investor generates capital gains by selling an asset.
Second, within 180 days, the investor reinvests the gain (notice that this does not require reinvestment of the full proceeds) in an “Opportunity Zone Fund” — which is a corporation or partnership holding at least 90% of their assets in Opportunity Zones, either directly or through stock or partnership interests in “Qualified Opportunity Zone Businesses.” There are, of course, restrictions on what can be a Qualified Opportunity Zone Business.
Third, the investor holds the Opportunity Zone Fund interest until the “Recognition Date,” which is the earlier of the date the investor sells the investment or December 31, 2026.
- If the Recognition Date is at least five years after the date the investor made the investment, then its basis is stepped-up to 10% of the value invested.
- If the Recognition Date is at least seven years after the investment date, then its basis is stepped up again to a total of 15% of the value invested.
Fourth, at the Recognition Date, the investor recognizes the gain (the amount invested minus the basis, whether that is 10% or 15% of the value invested), which yields a new basis equal to the full amount of the value invested.
Finally, if the investor holds the Opportunity Zone Fund investment for at least 10 years, then it may elect to step-up the basis one more time to the then-fair market value. Doing so and selling the property at that amount would eliminate all additional capital gains tax on disposition.
Opportunity Zones (1400Z-2) Are More Flexible than 1031 Exchanges
While 1400Z-2 has the obvious geographical limitation that doesn’t exist in a 1031 exchange, it is much more flexible in four significant ways:
- In 1031, the entire proceeds from the sale generating capital gains must be reinvested. 1400Z-2 requires only the gains be reinvested.
- 1031 is only applicable to real property, whereas 1400Z-2 applies to tangible property used in a trade or business, whether real or personal, as long as substantially all of it is located in an Opportunity Zone. This brings in the possibility of using the tool in relation to partnership interests, stock in corporations, and personal property.
- In a 1031 exchange, replacement property must be identified within 45 days, with limits on the number of properties that can be identified as replacement property. There are no such requirements in 1400Z-2.
- In a 1031 exchange, the replacement property must be like-kind. There is no such requirement in 1400Z-2.
How Opportunity Zone Investments Delay and Reduce Capital Gains Tax
Let’s walk through an example. Let’s say an investor generates $1,000,000 in capital gains through a transaction on December 1, 2018. Within 180 days, the investor puts the full $1,000,000 gain in an Opportunity Zone Fund, which purchases property in an Opportunity Zone. On December 2, 2028, it sells the property for $5,000,000. In this example, if done right, Section 1400Z-2 can allow the investor to recognize only $850,000 in capital gains and delay paying tax on that $850,000 for a little over 8 years, with the remaining $4,150,000 in gain being realized without capital gains tax. The investor can do all of that without tying up the proceeds from the December 1, 2018 transaction, except that portion of the proceeds that were themselves capital gains.
Here’s how: In this example, the two key dates are December 31, 2026 (the Recognition Date) and December 1, 2028 (the Disposition Date). On the Recognition Date, the Taxpayer receives a step-up in its income tax basis from $0 to $150,000 (15% of its $1,000,000 investment). Simultaneously, it recognizes $850,000 in capital gains (its $1,000,000 investment less its new $150,000 basis), even though there has not yet been a sale. Upon such recognition, its basis increases again by the amount of the recognized gain, from $150,000 to $1,000,000. Then, on December 1, 2028, the investor can elect to step-up the basis one more time, to the properties then-fair market value of $5,000,000, eliminating all remaining capital gains tax.
Where are These Opportunity Zones in Winston-Salem?
- Tracts 1 (37067000100) & 2 (37067000200) cover the downtown business district
- Tracts 3.01 (37067000301) & 3.02 (37067000302) cover the Boston-Thurmond and Kimberly Park neighborhoods
- Tract 7 (37067000700) is considered East Winston-Salem and includes sections of Wake Forest Innovation Quarter
- Tract 8.01 (3706700080) & 8.02 (37067000802) are south of Tract 7 and include Winston-Salem State University, the UNC School of the Arts and Happy Hill
- Tract 14 (37067001400) includes Whitaker Park and the Lawrence Joel Coliseum
- Tract 16.02 (37067001602) includes Smith Reynolds Airport and neighborhoods south of the airport
- Tract 17 (37067001700) is southeast of New Walkertown Road and includes the Winston Lake Golf Course area
With 1400Z-2, Opportunity Zones promise to be a powerful tool to the right investor in the right circumstances. It has the potential to allow investors holding significant unrealized capital gains to deploy them in communities in need an investment injection. We are looking forward to helping clients navigate this new investment vehicle.
About the Authors: Justin Hardy and Leigh Bagley
Justin M. Hardy is an attorney at the Winston-Salem law firm of Bell, Davis & Pitt. Justin focuses his practice on property tax appeals, intellectual property law, tax controversy law and general business law. Justin has practiced law in Winston-Salem since 2008, after earning his law degree at Michigan State University College of Law. He serves on the Community Advisory Board of 88.5 WFDD and on the Tax Section Council of the North Carolina Bar Association.
Leigh C. Bagley is an attorney at the Winston-Salem law firm of Bell, Davis & Pitt. Leigh focuses her practice on commercial real estate law, and banking and financial services. Leigh currently serves on the board of the Winston-Salem Business Inc. (WSBI). Until 2014, she served as an adjunct professor at the Wake Forest School of Law, where she also received her law degree.