For businesses and individuals alike, the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017 created and expanded numerous tax savings opportunities. One new feature of the TCJA is the Opportunity Zones program, which was designed to attract investment and promote job creation in economically distressed communities. While stimulating growth in these communities, Opportunity Zones offer a powerful way for investors to defer and reduce capital gains taxation.
In certain situations, investors in Opportunity Zones can enhance their tax savings by also pursuing a Cost Segregation study, which may yield accelerated depreciation deductions by simply reclassifying real property assets as personal property. As is the case with many complex tax issues, however, investors should consult their tax advisors to ensure that their strategy is legally compliant and designed to maximize tax savings.
What are Opportunity Zones, and how do they work?
Opportunity Zones are low-income census tracts that have been nominated by state governors and certified by the U.S. Treasury Department. As of 2018, approximately 8,700 communities across all 50 states, Washington, D.C., and five U.S. territories had been certified as Opportunity Zones.
In order to take advantage of the preferential capital gains tax rules offered through the Opportunity Zones program, investors must make their investments through Qualified Opportunity Funds (QOFs), which are partnerships, corporations, or real estate investment trusts (REITs) set up as vehicles to direct capital to communities in need. At least 90 percent of a QOF’s assets must be held in eligible Opportunity Zone property, including business property, real estate that is either new construction or has been substantially improved, and newly issued stock or partnership interests in a qualified Opportunity Zone business.
By investing in QOFs, investors may defer or reduce taxation on prior gains from the sale of stock, real estate, collectibles, businesses, and other assets. Since the program is designed to incentivize long-term investment in Opportunity Zones, investors will realize more substantial tax savings the longer that QOF investments are held. For example:
- If a QOF investment is held for fewer than five years, investors may defer payment of capital gains taxes on prior gains until the QOF investment is sold or exchanged.
- If the investment is held for five to seven years, investors may defer taxation until the investment is sold or exchanged, and will receive a ten percent exclusion of taxes on their existing capital gains.
- If the investment is held for seven to ten years, investors may defer payment of capital gains taxes until the QOF investment is sold or exchanged, or December 31, 2026—whichever is earlier. Additionally, investors may exclude fifteen percent of existing capital gains taxes.
- For QOF investments held more than ten years, investors will receive the same benefits as when the investment is held between seven and ten years, as well as an increase in basis equal to the investment’s fair market value at the time that it is sold or exchanged. As a result, investors can avoid paying any capital gains taxes on the appreciation of assets held in the QOF.
What is Cost Segregation?
Cost Segregation is an IRS-approved tax deferral strategy that enables commercial building owners to boost cash flow by claiming accelerated depreciation deductions. Generally conducted by tax professionals with engineering expertise, Cost Segregation studies analyze commercial buildings—which are depreciated over a period of 39 years—and reclassify certain assets within them as tangible personal property, which is depreciated over five, seven, or fifteen years. Therefore, Cost Segregation allows commercial building owners to take advantage of the shorter depreciation lives of personal property and capture accelerated depreciation deductions.
As a result of expanded bonus depreciation under the TCJA, Cost Segregation may prove even more lucrative. Bonus depreciation allows taxpayers to depreciate a percentage of the cost of eligible business property during the asset’s first year in service. Prior to enactment of the TCJA, taxpayers could only depreciate up to 50 percent of the cost of new property. The new law extended bonus depreciation to used property acquired after September 27, 2017, and allowed taxpayers to depreciate 100 percent of the property’s cost during its first year in service through tax year 2022. The amount that may be depreciated in the first year will decrease progressively after 2022. By performing a Cost Segregation study, building owners can more easily identify assets within the building that may qualify for bonus depreciation—which will help them reap the benefits of the generous 100 percent depreciation allowance while it is in effect. Therefore, now is an opportune time for commercial building owners to contact their tax advisors about Cost Segregation.
Opportunity Zones and Cost Segregation
As described above, Cost Segregation and investments in Opportunity Zones may each yield significant tax savings on their own—but taxpayers may further increase savings by investing in a QOF and then having the QOF pursue Cost Segregation for the fund’s qualifying investment properties. Using these two strategies in conjunction with each other would allow the investor to take advantage of the deferred capital gains taxation, step-up adjustments in basis, and gain exclusions that Opportunity Zones offer over the long-term, while also claiming immediate savings through accelerated depreciation deductions under Cost Segregation. However, pursuing both strategies may or may not be feasible, depending on the investor’s basis in the QOF.
Qualified Opportunity Funds may be funded with deferred capital gains, debt, and outside equity, or some combination of the three. An investor’s basis in the QOF may be affected by how the QOF is funded, as well as whether it is organized as a partnership or corporation for tax purposes. Generally, if the QOF is organized as a partnership and is funded with a combination of prior gains, debt, and equity (as opposed to only being funded with prior gains), the investors will be able to reduce their tax burdens through both the Opportunity Zone program and a Cost Segregation strategy. However, QOF investors should consult their tax professionals in order to ensure legal compliance and maximum tax savings.
Interested in learning more about the potential savings available through Opportunity Zones, Cost Segregation, or a combination of the two? Capital Review Group offers the tax and engineering expertise needed to help you optimize your savings through these powerful strategies. Contact CRG today to schedule a pro bono analysis!