Tax and financial advice from the Silicon Valley expert.

Opportunity Zones – A new “secret” tax benefit

Capital gains deferral for up to eight years?  Tax free investment growth?  Sounds too good to be true?

The Tax Cuts and Jobs Act of 2017, enacted on December 22, 2017 and mostly effective for individuals for 2018 through 2026, includes a tax benefit that hasn’t been widely discussed, yet.

The tax benefit is for investing in Opportunity Zones.  The reason it hasn’t been widely discussed is the investment community has been waiting for guidelines on how to implement the rules.  On October 19, 2018, the IRS issued proposed regulations for investing in Opportunity Zones (REG-115420-18.)  The proposed regulations answer many, but not all, of the questions relating to the new rules.

A summary of the tax benefits are as follows:

  1. Effective January 1, 2018 through December 31, 2026, if an individual reinvests short- or long-term capital gains from a transaction with an unrelated party within 180 days in Qualified Opportunity Zone (QOZ) property, the reinvested gain won’t be subject to current taxation, but will be deferred until the earlier of the date the QOZ property is sold or liquidated, or December 31, 2026. When it is taxed on December 31, 2026, the gain will retain its character as short-term or long-term capital gain.
  2. If the investment is held for at least five years, the potential tax on 10% of the reinvested gain will be forgiven by a basis adjustment to the QOZ property.
  3. If the investment is held for at least seven years, the potential tax on 5% of the reinvested gain will be forgiven by a basis adjustment to the QOZ property.
  4. This means that, provided the holding period requirements are met and the property is held through December 31, 2026, 85% of the reinvested gain will be taxable on December 31, 2026.
  5. If the QOZ property is held for at least 10 years and the taxpayer makes an election to do so, any additional gain from the ultimate sale or liquidation of the property will be tax free!

Note that only the gain is reinvested, and not the total proceeds like for a Section 1031 exchange.

The investor should keep a side account of cash or liquid investments to provide for paying the tax on the reinvested gain for 2026.  The source of the cash could be the capital recovery for the sale generating the reinvested gains.

The property will usually be acquired by an individual investing in a qualified opportunity fund, and not by a direct investment in the property.

The fund will be organized as a qualified opportunity zone business, conducting a trade or business within a qualified opportunity zone.  The assets of the fund, on average, must consist of at least 90% qualified opportunity zone property.  The proposed regulations include a safe harbor rule permitting the fund up to 31 months to invest the cash received in qualified property, provided the fund has a written plan for the investment.  A major question that hasn’t been answered is whether a rental real estate activity qualifies as a trade or business.  There is an example of converting a factory building to residential rental property in Revenue Ruling 2018-29 that indicates rental real estate should qualify.  (A real estate based business, such as a hotel, certainly does qualify.)

Qualified opportunity zones are designated by the governor for each state.  For example, the governor of California can designate up to 879 tracts, and a list of them are listed on a California Department of Finance web site.  The zones are economically depressed and primarily commercial.  However, many of them are located close enough to more economically advantaged areas to still offer good potential for economic returns.

Remember California has not conformed to this federal tax law.  The federal deferral and exclusions from taxable income don’t apply to California taxpayers and California source income for nonresidents of California.

There are a few aggressive fund managers who are already offering Qualified Opportunity Funds that invest in real estate, with the representation that they can’t guarantee the tax benefits, because of unanswered questions for the rules.

With the release of the proposed regulations, investors can have more confidence investing in qualified opportunity zone funds, but should still use due diligence and consult with their tax advisors before going ahead.  Investors should also consider how the investment fits in their total investment portfolios.

Equity compensation isn’t subject to Railroad Retirement Tax

The U.S. Supreme Court resolved a conflict of interpretation about whether employee stock options are subject to Railroad Retirement Tax.

The Court ruled that equity compensation isn’t subject to the Railroad Retirement Tax.

The retirement system for the railroad industry was nationalized by the Railroad Retirement Act of 1937.  Railroad employers pay taxes on employee compensation, somewhat like the social security system.

Under the Railroad Retirement Act, the tax applies to “any form of money remuneration.”

The IRS claimed that stock options should be considered to be “money remuneration.”

The Supreme Court said that money is understood to be currency issued by a recognized authority as a medium of exchange.  While stock can be bought or sold for money, it isn’t usually considered to be a medium of exchange.


What investments besides securities and bank accounts can you make with a Roth or IRA?

The interview on Financial Insider Weekly for this week is with Bill Neville, Certified IRA Services Professional of The Entrust Group. Our interview subject is "Making alternative investments with your IRA or Roth account."

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Tax and financial advice from the Silicon Valley expert.