Opportunity Zones

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Opportunity Zones

What are they?
Any area designated by the Federal Government as a “low income community” is eligible to be classified as an opportunity zone. States may declare 25% of their total eligible zones as opportunity zones.
 
Intent of the Legislation
Increase investment in the communities that need it the most. Impact Investing is important for low-income communities to grow and thrive along with the rest of the country. In theory, aligning private investment with low income communities promotes creation of new jobs and housing opportunities along with a general increase in wages.
 
Benefits for Investors
The Tax Cuts and Jobs Acts of 2017 (TCJA) gives taxpayers with capital gains an option to re-invest gains into disadvantaged areas throughout the US and defer/reduce their tax obligation. Upon sale of an investment and recognition of capital gains, the taxpayer has 180 days to reinvest their taxable capital gains into a qualified opportunity zone fund (QOZF). It’s important to note that the taxpayer does not have to reinvest their entire investment, only the portion taxable by capital gains. An investment of capital gains through a QOZF gives the
taxpayer a deferral on capital gains tax up to the earlier of the selling date of the QOZF interest or December 31, 2026. If the QOZF investment in the opportunity zone is held 5 years, the basis in capital gains will be reduced 10%. If the QOZF investment is held 7 years, an additional 5% of the capital gains basis will be reduced totaling a 15% reduction of the original tax basis.
 
Ex. Tom has unrealized capital gains of $100,000 from a concentrated stock position. Tom decides to sell out of his concentrated stock position and invest his taxable gains in a QOZF to defer payment of capital gains tax. After 5 years of holding his investment in the QOZF, Tom’s $100,000 taxable gain is reduced to $90,000. After 7 years, Tom’s taxable gain is reduced to $85,000
 
If the QOZF asset is held for 10 years, then all capital gains on the QOZF asset will be exempt from tax.
 
Eligible OZ Investments
As individual investors, it may not be important to understand what qualifies under the TCJA as an OZ investment since the QOZF decides what to invest in. An QOZF may invest in real business property, stock, or partnership interest for any businesses operating within the zone.
 
Final Notes
Currently there are some loose ends that needs to be finalized with legislation. One issue that continues to persist involves rulings for investments in stock for businesses located within the opportunity zones. Legislation states any business operating in an opportunity zone must derive at least 50% of their revenue from within the zone. This poses an issue for investors who want to headquarter internet companies in the zones since internet companies derive their revenue from locations throughout the US and internationally. For more information on the legislation or advise for personal tax situation, consult your financial advisor or tax professional.

OZ Calculator

Opportunity Zone – What is it?
The Tax and Jobs Acts of 2017 created an investment vehicle for capital gains. An investment of capital gains through an Opportunity Fund gives the tax payer a deferral on capital gains tax up to December 31, 2026. If the investment in the opportunity zone is held 5 years, the basis in capital gains will be reduced 10%. If the investment is held 7 years, an additional 5% of the capital gains basis will be reduced, totaling 15% of the original basis. If the asset is held for 10 years, then all capital gains on the Opportunity Zone Investment will be exempt from tax. Any area designated by the Federal Government as a “low income community” is eligible to be classified as an opportunity zone. States may declare 25% of their total eligible zones as opportunity zones.
 

Opportunity Zone – Why?

Increase investment in the communities that need it the most. Impact Investing is important for low-income communities to grow and thrive along with the rest of the country. In theory, aligning private investment with low income communities promotes creation of new jobs and housing opportunities along with a general increase in wages.

W&A Calculator

For potential investors, we encourage you to utilize our OZ Calculator. This spreadsheet compares two investment scenarios for an investor with capital gains. Scenario One: Reinvest capital gains into an Opportunity Zone Fund. Scenario Two: Pay taxes on capital gains and re-invest the proceeds in an alternative investment.

At first glance the calculator may seem like a lot, but only numbers in blue need to be toggled by the user. Let’s look at the first part of the calculator and go over the parameters.

 

  • Initial Investment: Capital gain being reinvested into OZ / Alternative Investment.
  • LT Federal Cap Gains: Federal capital gains. Varies by state.
  • Net Investment Income Tax: Additional tax on high earners.
  • State Income Tax: Capital gains tax at the state level.

This will create the total capital gains tax rate effective. You may wish to consult your CPA or tax attorney as rates vary by state and income levels.

  • Annual Appreciation of OZ Fund / Investment: Year over year growth in asset value (OZ capital gains).
  • Annual Return of Alternative investment: Year over year growth in alternative investment (Alternative investment capital gains).

For the cross comparison of the OZ investment to the alternative investment, yearly asset appreciation assumption must be made. In the above scenario, 7 % is assumed on the alternative since that is what an Investor in W&A typically returns. For the OZ asset a more conservative estimate is recommended due to the nature of impact investing.

  • OZ Income (Rent): Rental Income generated. Can also be business dividends in the case of an OZ equity investment.
  • OZ Growth Rate: Projected annual growth in rental income.
  • Rental Income Tax: OZ investors must pay taxes on income received from the OZ. Listed is the applicable income tax rate.
  • Medicare Surtax: Standard rate levied on investment income for certain income levels.

Income parameters are important to measure the net value each investment vehicle provides. Since most OZ funds invest in business property as the underlying assets, rental income on yearly basis must be assumed. Also, an increase in rental income should be included to account for yearly growth.

  • Alternative Income (Dividends): Dividends income from alternative investment fund or portfolio. Calculator assumes reinvestment each year for compounding effect.
  • Dividend: Federal Income Tax: Fed tax rate on dividend income from alternative investment.
  • Dividend: State Income Tax: State tax rate on dividend income from alternative investment.

The alternative investment is typically bonds, equity, some real estate, and niche asset classes that return a yearly dividend to the investor. Dividends are reinvested into the alternative investment, but taxes are paid in year revenue is recognized.

  • Depreciation: Asset value and useful life are already predetermined since it’s based on the initial capital gains and the LTV ratio specified. Also, buildings and other real estate almost always depreciates on a 27.5-year timeframe.
  • Financing: Enter information here if you plan on using leverage for the opportunity zone investment. Something that is important to not is most OZ Funds will have a leverage / refi component which means you should include them as well if you plan on investing in a fund rather than self-certifying. LTV is the loan to value ratio, construction loan interest is the interest on the original loan taken out to build the property, and stabilized loan interest is the rate on the refinanced debt.
  • Refinance: The amount listed in the “Refinanced Loan Amount” row is the loan that will be taken to refinance the construction principal. Debt to yield is the rate the user specifies which will give them the loan amount. This metric is not uniformly useful for every investor and it could give an inaccurate loan amount. Year of refinance is the year the new loan will be activated to pull out equity from the real estate to help with inherent liquidity issues.
 

This calculator is solely for informational purposes and should not be construed as tax or legal advice. It is only intended to provide education about the financial industry. Results and future estimates of back-tested performance are hypothetical. Investing in opportunity zones are extremely limited and not suitable for all investors as they may face heightened risk due to the illiquid nature of investment opportunities available through the Tax Cuts and Jobs Act of 2017 (TCJA). To determine whether investing in opportunity zones is appropriate for you, we urge you to please consult your financial advisor prior to investing.

Wambolt & Associates is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Wambolt & Associates and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Wambolt & Associates unless a client service agreement is in place.