A recent article on GlobeSt.com addresses some misconceptions about Opportunity Zones, or as I refer to them, “oZones”.
What really caught my attention in the article and a really big gotcha is addressed in the last portion of the article in which Marc Wieder points out that there is a tax reckoning day. The article is correct in pointing out that a portion of the tax deferment will be due in 2026. With this being said, the potential benefits of oZones, remain.
I think that it is important to distinguish the tax deferral benefits from the adjusted basis benefits, for tax purposes in order to understand the significance of the 2026 deadline.
For illustrative purposes, let's assume that in 2008 Joe purchased a 4-plex. In February 2019 he sold it, realizing a capital gain of $700,000.
In March 2019, he invests the full amount of the capital gain, from the sale of the 4-plex, into a 20-unit, multi-family complex, ("20-unit"), located in an oZone. in March 2019, he would be able to defer the capital gain of $700,000 realized from the sale of the 4-plex, only until 2026. When he files his taxes for 2026, he will have to claim the $700,000 capital claims, whether or not he sold the 20-unit. The hard deadline on the tax deferral is a major distinction between a 1031 Exchange tax deferment and that being offered by the oZone legislation. In a 1031 Exchange, taxes on the capital gains are not due until the property is sold and the gains are not rolled over into another 1031 Exchange.
This is where the gotcha comes in, but only comes into play if the investor does not properly plan for 2026.
First, I anticipate that most investors who will consider oZone investments versus a 1031 Exchange will consider an oZone investment because of its, very favorable tax treatment, (increased basis). This is where all of the current excitement is. Stated in lay terms, if Joe holds the 20-unit 5 years, (March 2024), in addition to the deferment on the taxes on the capital gains of $700,000, he gets to write-off 10% of any of the capital gains he might realize on the eventual sale of the 20-unit. If Joe holds 7 years, he gets a 15% write off. If he sells the 20-unit in 2026, he will have to pay taxes on the deferred gain and only 85% of any capital gains on the 20-unit. Depending upon the gain on the 20-unit, this could be a very favorable result as compared to a 1031 Exchange.
Where things get sticky is if Joe decides to hold the 20-unit for 10 years or through February 2029. The 10-year hold period entitles Joe to write of 100% of his capital gains on the 20-unit, but not the gains realized from the sale of the 4-plex. In this instance, he would be obligated to pay his taxes on the capital gain from the 4-plex in 2026 and would need to resort to sources of funds to pay the taxes on the 4-plex capital gains, other than from the sale of the 20-unit. If Joe has the funds to pay the taxes, it shouldn't be a problem. However, if Joe needs to sell the 20-unit in order to pay the deferred taxes on the 4-plex, he would not be entitled to the full 100% write-off.
I anticipate that part of the analysis and planning at the time of purchase of the 20-unit would be to:
Putting aside funds on a monthly, quarterly or yearly basis, that would be available in 2026 to pay the capital gains on the 4-plex, should Joe decide to hold the 20-unit beyond 2026;
Regular analysis of the value and profitability of the 20-unit to determine the potential value to Joe, holding 5, 7 or 10 years.
I hesitate to call Joe's situation simple. However, with proper planning, it should be manageable. To properly plan his options before the investment and during an oZone hold period, he needs a multitude of tax, legal and real estate experts to continuously evaluate his investment and future, plan. However, his situation with a sale and purchase in 2019 seems much less problematic as compared to an oZone investment in 2021 and beyond. So, for example, if Joe didn’t sell the 4-plex until January 2023, based upon the current law and rules, he can only defer his capital gains tax to 2026, greatly diminishing the value of the oZone investment versus a 1031 Exchange. Note, that even with the shortened deferral period, Joe can still write of 10%, 15% or 100% of the capital gains on the 20-unit, depending upon how long he holds it.
Finally, please remember that all of this is subject to finalization of the rules, which still seems months away and perhaps changes in the law. It seems to me that if Congress feels that the oZone legislation has been worthwhile, they may extend the 2026 tax deferral deadline.