Hamill: Tax breaks hide in opportunity’s overalls

There has been a lot written about the new tax bill passed last July. Little attention has been paid to what is being called Opportunity Zone 2.0.

Thomas Edison said, “Opportunity is missed by most people because it is dressed in overalls and looks like work.”

The opportunity zone provisions first appeared in 2017. These rules are now called Opportunity Zone 1.0 because we have a new set of rules.

Both “OZ 1.0” and “OZ 2.0” require a lot of effort to understand. Not everyone is a candidate to use either of these provisions.

But there are some people who might be a candidate for an OZ investment, though they miss that opportunity because the rules require work to understand.

Most tax rules require work. But a taxpayer can often rely on their tax adviser to learn and apply the rules. Let someone else wear the overalls.

Unfortunately, the OZ rules are not well known by tax advisers. So today, I will provide a primer on how OZ rules work.

It all starts with a realized capital gain. That gain is ordinarily placed on your tax return, increasing the tax due in the year of realization.

If you choose, you can instead invest the amount of that gain in a qualified opportunity fund, or QOF.

Capital gains can be from any source. Most tax deferral provisions require that the new investment be like the one that produced the original gain.

OZ gain deferrals can be completely different investments. A capital gain from the sale of Apple stock can be invested in a real estate QOF.

The investment must be made within 180 days of realizing the gain, with special measurement rules applying to gains realized within a partnership or S corporation.

You must also elect to defer the gain. If all the boxes are checked, the capital gain can be deferred to a later tax year.

In OZ 1.0, the gain would be deferred until 2026 (yes, this year). If the deferral were made in 2018 or 2019, you could also eliminate 10% of that gain.

For investments made in 2020 or 2021, 5% of the gain could be eliminated. This could be combined with the 10% for a 15% total exclusion.

The real benefit of OZ 1.0 is that any appreciation in the investment after the initial investment could avoid any tax effect if the investment is held for 10 or more years.

An OZ investment is one made in a designated low-income census tract. OZ 1.0 designations were made by individual state governors or their designees.

The ability to defer gains from OZ 1.0 ends this year. The reason was to allow an evaluation of the efficiency of the provisions.

The most recent tax bill extended the OZ rules, but in a different form now known as OZ 2.0.

The new rules require a new designation of an opportunity zone. The new designations have more restrictive requirements than the initial rules.

These new designations will begin on July 1. Right now, we do not know which census tracts will qualify for an OZ 2.0 investment.

The new designations will also include a rural opportunity zone. More favorable gain exclusion rules apply to these rural zones.

The OZ 2.0 investments will begin Jan. 1, 2027. A gain realized in the second half of 2026 could be deferred to OZ 2.0 through the 180-day investment period.

The OZ 2.0 rules allow a gain to be deferred for five years from the time the investment is made.

The OZ 1.0 rules allowed the deferral until the end of 2026, which might have been more or less than five years based on the timing of the gain.

The OZ 2.0 provisions create rolling five-year deferral periods because everyone gets the full five years (provided they stay in the investment).

The OZ 2.0 rules allow the investor to exclude 10% of the original investment after five years. This can be 30% for rural zone investments.

Winston Churchill said, “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”

These rules are complicated. That turns many people off. I encourage you only to consider this if it applies. Try to keep some optimism in the opportunity.

Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.