Executives and investors often think of the tax code as a cost of doing business or drag on an investment, but many provisions in the law were created to reward taxpayers for certain behaviors. Similar to how tax deductions encourage charitable contributions, the tax code can incentivize investors to deploy their assets for societal good — also known as “impact investing” — which investors are increasingly identifying as an important personal goal. Over time, we’ve found that many clients want their investments to make a positive social impact at the same time they do well in terms of after-tax returns.
The recently enacted Tax Cuts and Jobs Act (TCJA) offers a new tax incentive to those who invest in certain low-income communities designated as “opportunity zones” (O-Zones). Thousands of communities have been qualified for participation in the program, ranging from inner-city neighborhoods to rural farmlands. The process of qualifying for the tax advantage involves several steps, and the opportunity is currently scheduled to expire in 2026. The sooner you get started, the more time you’ll have to defer the gain.
Step 1: Generate a capital gain
The old cliché that “it takes money to make money” was never truer than when it comes to O-Zones. This incentive is only available for capital gains generated by the sale of appreciated assets.
Step 2: Invest the gain in an “opportunity fund”
The O-Zone rules differ from some previous low-income investment incentives, in that the taxpayer doesn’t buy the property in the zone directly, but instead invests in an “opportunity fund” that holds at least 90 percent of its assets in qualified opportunity zone property. Consider:
- Investors looking to reduce and defer tax on gains and support the communities served by a fund might be best served by finding a qualifying fund. Typical fund investment analysis rules still apply. Make sure that the fee structures and investment goals align with your criteria.
- A business that wants to purchase or relocate assets in an O-Zone might be best served by creating its own opportunity fund. By completing a relatively simple registration process, you can create and manage a fund that’s focused only on the qualifying property that you own.
This investment provides your first O-Zone tax break, as you defer the tax on the capital gain that is invested in a fund within 180 days.
Step 3: Be patient
The tax rewards increase the longer you hold the investment:
- After five years, investors get a 10 percent “step-up” in basis on their original investment in the fund, meaning that 10 percent of the gain originally invested will no longer be subject to tax.
- After seven years, investors get an additional 5 percent step-up, meaning that a total of 15 percent of the original gain invested is no longer subject to tax.
(Note: The invested gain is subject to tax no later than Dec. 31, 2026.) - After at least 10 years, investors can elect a step-up in basis on their investment in an opportunity fund, providing what amounts to a permanent exclusion of capital gains on the appreciation of their investment upon the sale of their investment in an opportunity fund.
Generating a social, as well as financial, benefit
Impact investing strategies rarely come with such a significant tax incentive. The growth of an investment in a qualified opportunity fund can deliver the unusual combination of social, community, and individual financial benefits. As of now, however, the opportunity is only available for investments made on or before Dec. 31, 2026.
We anticipate the IRS will release further regulations soon, which will give even more details about how to best utilize this incentive. As mentioned above, the sooner gains are invested in an opportunity fund, the more positive impact they can make in an opportunity zone — so act now. To learn more about how your business or portfolio can gain a tax advantage by investing in low-income opportunity zones, please contact Plante Moran.
