You probably need to prepare for the holidays you and your family celebrate. Or maybe start work on some year-end accounting.
Accordingly, I want to make this a short post and talk just a little bit about qualified opportunity zones.
Specifically, I want to provide a primer for small business owners and entrepreneurs. We’ll briefly discuss how these things work. And then before someone drunk with enthusiasm goes out and tries to use this new loophole, we’ll talk about some practical difficulties people will surely encounter.
But let’s start with why these things are attractive…
Qualified Opportunity Zones in a Nutshell
Qualified opportunity zones provide three tax benefits to investors and entrepreneurs.
First, if you reinvest capital gains you’ve earned on some other investment into a qualified opportunity fund, you delay paying the taxes on the capital gains until as late as December 31, 2026. Some nit-picky rules exist. (Talk to your accountant about these.) But, essentially, the first benefit is that you delay paying taxes on some realized capital gain.
Example 1: You sell an investment and realize a $1,000,000 capital gain. You reinvest the $1,000,000 into a qualified opportunity fund, however, and so don’t need to pay the taxes on the gain until December 31, 2026.
A second benefit: If you hold your new investment in the qualified opportunity zone for at least five years, you exclude ten percent of the capital gain. And if you hold your new investment for at least seven years, you exclude fifteen percent of the capital.
Example 2: That $1,000,000 re-investment described in Example 1? Suppose you make that re-investment on December 31, 2019. On December 31, 2026, you owe taxes. But because you have held the investment for seven years, you exclude 15 percent of the $1,000,000 gain from your taxable income and so avoid taxes on $150,000. (You do owe taxes on the remaining $850,000.)
A third benefit: If you hold a qualified opportunity zone investment for at least ten years, you don’t owe taxes on the increase in value of the investment in the qualified opportunity fund.
Example 3: You make the $1,000,000 re-investment described in examples 1 and 2. And on December 31, 2026, you do end up paying capital gains taxes on $850,000 of the previously realized gain. However, you don’t sell the property until 2030 when you sell the property for $2,000,000. The second $1,000,000 of gain? You don’t pay taxes on that.
The Devil in Details
The preceding paragraphs brush over the gritty details of the qualified opportunity zone loophole.
But you want to know two important details.
Detail number one? Qualified opportunity zones are “distressed” areas where federal and state governments want to “spur” economic activity. (Here’s a link to one of the online lists available: Opportunity Zones list.)
Detail number two? These things, while potentially giant tax savers, get complicated. (See Forbes columnist Tony Nitti’s discussion of Qualified Opporutnity Zones for a great discussion of the details.)
But let me put this into perspective. As just a rough guess? I estimate setting up your own qualified opportunity fund to make some entrepreneurial investment increases your accounting costs by an extra $10,000 a year.
Example 4: Your accountant used to charge you $1,000 a year for your business tax return. But now, with the extra work related to the qualified opportunity fund , the price runs $11,000… so a $10,000 bump in cost.
And Now that You Know Lay of the Land
Again, I’m not even sure you should be reading stuff like this. You probably have holiday preparations to take care of, right? Maybe year-end to-do lists that need to be cleared?
So let me make this quick. I have three closing comments for you.
First, I don’t think you let qualified opportunity zones influence your tax planning or entrepreneurship. The tax benefits sound good. I grant you that. But for small business investors, the annual accounting costs run too high.
Example 5: If you did make the $1,000,000 investment described in examples 1, 2 and 3 and saved yourself from paying a 20 percent capital gains tax on $1,150,000, your tax savings equal roughly $230,000. That sounds great! But you would have paid per my estimates an extra $100,000 in tax accounting fees. (I calculate this value by saying you pay an extra $10,000 a year for ten years.) That’s not worth it by my calculations.
Note: Remember that in the given examples the $230,000 in capital gains savings occurs when your $1,000,000 investment in some struggling “qualified opportunity zone” doubles in value. But that may not occur. And then note, you will end paying the $100,000 or whatever in extra tax accounting fees.
A second comment: I think the requirement to pay the taxes you owe by December 31, 2026, even considering the ten percent and fifteen percent exclusions, means you’re sitting on ticking time bomb.
Example 6: You make a $1,000,000 investment into a qualified opportunity zone and on December 31, 2026 must pay the, say, twenty percent capital gains tax–so $170,000–on the $850,000 of gain you need to recognize. Unfortunately, your investment in an economically distressed neighborhood has struggled. And you can neither get financing from a bank or sell out to some other entrepreneur to get the money to pay your taxes.
My third and final comment: Suppose you happen to find yourself investing in an area that only coincidentally qualifies as a “qualified opportunity zone.” In other words, your investment makes sense regardless of the qualified opportunity zone loophole.
In this special case?
Yeah, I think you do talk with your accountant about using this new tax law. Sure. You probably will jack your tax accounting fees by thousands of dollars annually. But you might save a bundle.