In 2017, the new tax law created something called “opportunity zones (OZ).”
An investor may invest cash into an OZ and obtain as many as four tax benefits.
First, the investor may defer a capital gain until Dec. 31, 2026. Second, if the investor is in the OZ for five years by the end of 2026, 10% of the deferred gain is eliminated.
Third, if in the investment for seven years by 2026 (which requires a 2019 investment), another 5% of the deferred gain is eliminated.
These three benefits allow only a deferral of the gain invested in the OZ. The big tax benefit applies only if the investor is in the deal for 10 years. If so, any gain on the investment itself (not the original deferral) escapes any tax.
Assume Mary had a $2 million capital gain in 2019. Mary invested $2 million in an OZ fund in 2019. In 2026, Mary will pay tax on $1.7 million of deferred gain. This is the $2 million gain reduced by the 15% adjustments allowed for a seven-year investment.
So Mary pays a chunk of tax in 2026. However, this was from a 2019 gain so she gains the benefit of tax deferral. She also eliminates 15% of the gain from her tax base.
Now let’s say her $2 million investment grows to $6 million by 2030. The $4 million investment gain escapes tax entirely.
That’s the basics. Let’s now add that Mary is 76 years old in 2019. When the OZ deal was pitched to her it sounded attractive, but she thought, I’ll be at least 86 by the time I can get that 10-year tax benefit. The age thing is a concern for many investors looking at a 10-year investment horizon. So let’s add that Mary is a widow with $20 million of assets and a few kids.
Mary might consider a tweak to the OZ plan. After making her investment in 2019, she transfers her OZ investment interest to something called a “defective trust.”
Well that doesn’t sound very smart. Who wants a defective trust? Turns out many people do. If you ever watched the old Batman show, you must have tried to solve the Riddler’s riddles.
The more you take away from it, the larger it grows. What is it? Had the Riddler earned a tax degree he would have asked, when can a defective trust be effective?
The answer to the first riddle is a hole. A defective trust is effective as a means of transferring the trust property out of your estate. You have made a gift of the property.
It is defective only in shifting the tax burden from trust assets to the beneficiaries. That can be a good thing.
When Mary transfers her OZ investment to a defective trust, she has made a gift. If done early, before the property appreciates, the gift amount can be reduced.
In 2026, Mary will pay tax on the deferred gain. This is because the trust transfer is ignored for income tax. The gift also does not disqualify the OZ investment for future benefits (a “normal” gift will) precisely because it is income tax defective (essentially ignored).
Let’s say that Mary dies in 2028, before she can realize the fruits of her fine investment decision. The beneficiaries of the trust are now the owners of the OZ investment.
Because the trust was effective for gift purposes, Mary’s death does not allow her heirs to benefit from the basis step-up the tax law normally allows for inherited property. This can be a downside to the defective trust.
But with the OZ, the heirs will be able to get the 10-year tax basis adjustment that eliminates any tax on the $4 million investment gain. This comes from the OZ rules and does not need the inherited property rules to apply.
The result is that Mary pays tax on “her” 2019 gain in 2026. Mary’s untimely death does not cause a loss of a basis step-up because the 10-year OZ benefit covers what the estate rules will not.
This gift shifts appreciation out of the estate and still allows the heirs an income tax basis adjustment.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.
