How to Protect Your Capital Gains with Opportunity Zone Investments

If you sold your property within the last 180 days, you can reinvest that capital gain and defer and reduce the tax you’ll have to pay at filing time. If the income results from the sale of assets in a partnership filing K-1, the 180 days runs from the end of the calendar year.

In this article, we’ll give you a concise overview of what opportunity zones are, how to get started investing, and why and how you might want to create your own qualified opportunity zone investment fund (QOF).

What Are Opportunity Zones? How Do They Protect My Capital Gains?

If you’ve recently realized capital gains (made a profit) from the sale or transfer of personal or partnership assets and you’re facing the payment of a large tax liability to the IRS – current capital gains taxes range as high as 20% depending on your income– opportunity zones allow you to put off or defer paying taxes as long as the investment is held in the QOF.

The Tax Cuts and Jobs Act of 2017 (TCJA) created the opportunity zone program to provide a financial incentive to investors for allocating capital to economically disadvantaged communities. The Act created more than 8700 designated qualified opportunity zones (QOZs)

What exactly are the benefits of investing in opportunity zones?

  • You can earn strong returns and pay no more than the original deferred tax (reduced by incremental step-ups in basis).
  • 10% step-up in basis after 5 years. Pay tax on only 90% of original gain.
  • 15% step-up in basis after 7 years. Pay tax on only 85% of original gain.
  • Complete elimination of tax on post-investment capital gains after 10 years.
  • Pay tax on only 85% of original gain if held more than ten years. No tax on subsequent gain.
  • You can invest in business or real estate assets.

Investing in opportunity zones allows you to protect your retirement and heir’s inheritance from excessive taxation by the federal government.

If you’re willing to commit to a 10-year investment, you can reduce your tax basis by 15%, and pay no capital gains tax on any new gain.

How Do I Get Started Investing in Opportunity Zones?

The first consideration is finding a QOF. Per the TCJA, QOZ investments must be made through a QOF.

There are two ways to approach this: you can either invest with an existing QOF or create your own by self-certifying with the IRS using form 8996.

Working with an existing QOF is a good choice if you’re looking for professionally-managed investments that won’t require you to be personally involved in property or asset management.

If you want more control over your money and investments, it’s not too difficult to self-certify as a QOF.

Now, the list of qualifications/requirements is a bit intimidating, but here’s a brief summary­–consult an investment advisor and accountant:

  • 90% of the funds assets must be held in opportunity zones.
  • Eligible entities include corporations, partnerships, and LLCs (those treated as a partnership or corp for tax purposes).
  • Self-certify with form 8996. No application or approval requirement.
  • QOF assets must be placed into service in a QOZ for the first time by the QOF, or
  • Be ‘substantially’ improved within 30 months.

Tips For Aspiring and Professional Opportunity Zone Investors

If you have capital gains to reinvest and the tax benefits are something that fit your financial and tax needs, you’ll need to proceed with caution before making a pledge.

Take care in researching, interviewing, and reviewing the offering memorandums of the QOFs you consider. Select a fund that specializes in the types of assets in which you’re most interested and that has a track record in QOZ investments or business and real estate development.

Creating your own QOF sound most appealing? Do your homework, evaluate your relevant experience, skills, and enlist the counsel and aid of real estate, legal, finance and other associated professionals to lend capability and credibility to your team.

Finally, inclusion in an opportunity zone doesn’t mean a great investment. Evaluate the market based on population growth, rental rate trends, quality educational institutions, strength of industry, zoning policy, and numerous other economic, regulatory, and social considerations.

Once you find a property or investment, conduct the same due diligence in assessing its condition, cash flow, and functional utility (livability and usefulness for modern buyers). Depending on the QOF, you can invest in an individual property or portfolio of units.

Time is of the Essence

Take action now to research your options if you need capital gains tax relief. You have a limited period from when gains are realized until they must be contributed to qualify for the tax-deferral benefits.

Depending on your background and how involved you want to be in the investment, you can either invest in an existing QOF or start your own and self-certify with the IRS.

Whichever path you choose, do your due diligence and select an investment based on the factors that you would consider for any traditional opportunity. When you choose a QOZ investment in a market with strong rental demand, favorable local policy, and economic growth, you’ll have a stable-return asset that shelters your existing and long-term gain.

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When Capital Gains Taxation Applies to Residential Real Estate

Current and future taxes affect a real property’s return on investment. For residential real estate investors, capital gains taxes vary by situation. Why a property was acquired and how it was occupied will determine whether an investor will owe capital gains tax upon resale.

What Are Capital Gains Taxes?

Capital assets are generally defined as significant properties, owned by a taxpayer, that have a longer useful life of more than one year and would not be offered for sale in the normal course of business. Some governments charge taxes upon a property’s sale on its ‘capital gain’ or the difference between the original cost of the property and its later sale price. Federal capital gains taxes apply to all sales of private real estate in the United States. Individual states treat capital gains in different ways; in New England, all states (except New Hampshire) charge capital gains taxes.

The U.S. government has been collecting capital gains taxes since 1913. Federal capital gains tax laws have changed many times since then; the most recent changes came with the ‘Tax Cuts and Jobs Act of 2017’, starting with the tax year 2018. That recent act continued capital gains taxation, but it altered the tax rates, based on a taxpayer’s tax bracket.

Capital Gains Taxes on Residential Real Estate

Privately owned residential real estate is subject to federal capital gains taxation, though some special considerations apply to owner-occupied homes. By federal law, home sales are exempt from capital gains taxes when the seller has owned and used a home as their primary residence for two out of the last five years. If those conditions aren’t met, the exemption may also be allowed when ‘unforeseen circumstances’ occur, such as job loss, divorce, or family medical emergency. The exemption applies to capital gains up to $250,000 for individuals and $500,000 for married couples.

According to the I.R.S., the original cost of property—or its ‘basis’—includes its price, the fees and commissions paid to buy it, and the costs of any major improvements made to it after purchase. For property acquired by inheritance, the basis is usually the property’s market value as of the decedent’s death date. Likewise, the basis for a property received as a gift is its market value on the date it was given.

Residential real estate used mainly for rental does NOT qualify for the owner-occupancy capital gains tax exemption. However, if only a piece of the property was rented or used for business purposes while a substantial part was the owner’s primary place of residence, capital gains for the owner-occupied section is probably tax-exempt. In this situation, the I.R.S. provides detailed guidelines for calculating the portion of capital gains that would not be subject to taxes.

Planning Up Front

The ideal way to minimize capital gains taxes is to keep detailed records. Those records should include (a) complete information about the property’s use during the taxpayer’s ownership and (b) proof of all costs of any major improvements made after the property was acquired. The records will substantiate the taxpayer’s occupancy claims and support their basis estimate. When a residential property was purchased expressly for rental use, incurring capital gains taxes will be a near certainty at the time of sale. Some investors will set aside a portion of rental for those taxes; others account for them as a deduction from future sale proceeds.

Expert advice will help a residential-property buyer realize the highest return on investment. A good accountant stays current on recent real estate tax regulations, and they will be able to guide an investor to the investor’s best approach. Lastly, a real estate professional with specialized training and investment property experience is crucial to helping both buyer and seller achieve maximum returns.

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Should I Sell My House or Turn It into a Rental Property?

Sometimes, a homeowner can choose whether to sell a single-family residence or keep it for rental income. This option often presents itself to an owner who has saved enough cash to use as a down payment for a new primary residence. Also, this decision-making predicament is typical of someone who has inherited a house, has purchased a building for a child’s college years, or is relocating temporarily. Every one of these choices is viable under different circumstances; a homeowner who considers all the associating factors of each option will more likely reach the best conclusion.

Legal and Financial Considerations: Your Key to Navigating the Slippery Road of Rental or Occupancy

Local zoning laws and covenants occasionally prohibit rental of single-family residences. Check the local zoning authority and homeowners’ association to confirm that your rental is permitted. Mortgages on single-family residences often require the borrower to be the principal resident of a home. This will require an owner to have either paid off existing loans or work with the lender to modify the terms of those loans.

Using a house as a rental property is a form of investment. A wise investor compares a house rental with other investments to determine whether rental generates the greatest return. Return on investment usually includes both net cash flow and change in equity: a house’s resale value determines equity change. So, an investor also needs to research the housing market to know if their house is likely to increase in value over time.

Investors also consider the tax implications of renting out a house. Normal expenses—such as repair, maintenance, real estate taxes, and leasing costs—can be deducted from rents, resulting in a lower taxable income. The costs of acquiring and improving a house can be also be subtracted from taxable income by using a depreciation process. But a homeowner’s standard exemption from capital gains taxes is not allowed for rental property.

Practical and Management Factors

Renting out a house is an active (rather than passive) investment. That means the owner must deal with leasing, management, and maintenance concerns. The owner will not only have the time and ability to take care of these issues, but they must also set aside some money for scheduled maintenance or unexpected emergencies.

The landlord role can be daunting and aggravating; if a house owner instead opts to pay for professional management, that cost will substantially reduce net income flow. Risk for a rental house investment can also be relatively high. Tenants may damage the property, leave without paying rent, or require eviction. Liability insurance can offset some of these risks as well as relieve the owner of any responsibility should a tenant be injured in the rental house.

A Third Option: Providing Seller Financing

An alternative way of generating cash flow while avoiding the complications of rental is to sell a house and provide the financing for part or all of the sale price. Again, if there is still a mortgage on the house, the original loan may not allow owner financing. Even when owner financing is permitted, the original loan is primary, meaning the lender has first right to repayment; the owner-lender becomes secondary or junior. Therefore, if a buyer defaults, the first owner is still responsible for mortgage payments, and the house still is collateral for the original loan. Besides that, providing owner financing does carry some tax benefits. Income tax applies only to the interest portion of loan payments and capital gains taxes are spread over the life of the loan.

There are certain financial insecurities associated with providing owner financing. The buyer-borrower could default on the loan. Most borrowers do not remain in homes for the regular financing periods of 20 to 30 years, suggesting that the original owner will require a balloon payment upon resale. Professional legal and accounting services are necessary for the owner-lender to ensure safety and maximum investment returns.

Research, Then Decide: Equip Yourself with Market Information before Investing

A variety of factors will influence a home owner’s decision to sell or rent out their house. Rental must be permitted under local zoning laws and covenant restrictions. The existing loan on a primary residence will likely prohibit rental use. Rental might be dependent on free and straightforward ownership or available commercial financing. Once in a while, other investments out-perform rental houses: a homeowner should thoroughly investigate the rental market, probable expenses, and potential rental income, and compare the net income to competing investments. Part of the total investment income will be the eventual resale proceeds from a house. In a stagnant or declining market, those proceeds may be minimal. Managing rental property requires time, resources, and resilience. A possible alternative is selling the property with owner financing to generate an income stream with much less active owner involvement, yet with tax benefits.

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Are My Real Estate Taxes Too High?

Local real estate taxes are charged to nearly all privately-owned properties, including residences. These taxes pay for many public improvements such as infrastructure, schools, libraries, parks, police, and fire protection. Homeowners are not averse to paying taxes. They expect to pay their fair share of taxes, although not more than their neighbors with similar properties. Understanding how taxes are assessed, whether those taxes are reasonable, and how to reduce inflated taxes is important for any real estate owner.

Elements of a Tax Bill

A real estate tax bill is made up of two parts: property tax rate and assessed value. The property tax rate is applied to a property’s assessed value. The local property tax rate is determined by a town’s Board of Assessors, based on projected town expenditures for the coming year. The Board of Assessors also develops opinions of fair cash value (as of January 1 of the prior fiscal year) for every property in its jurisdiction. The property tax rate is expressed in number of dollars per thousand dollars of assessed value. So, if a home is assessed at $100,000 and the tax rate is $25 (.025), the tax bill is $2,500.

Researching Your Property’s Real Estate Taxes

The first step to understanding your property’s tax bill is to review the assessor’s description of the property. Most assessors’ offices keep property records in online databases; therefore, you can research your house’s assessment record from anywhere with internet access. Your property records are located in the assessor’s section of your town’s website. The assessor’s record will include a detailed description of your house, including its lot size, year of construction, square footage, number of bedrooms and bathrooms, and special features, such as fireplaces and air conditioning. The record will also specify whether your property is residential, commercial, or industrial.

Furthermore, the record will reflect the property’s sale history and past assessed valuations. Those valuations will include separate value estimates for the property’s land and improvements. The assessor’s value estimates are created using a mass appraisal system. An assessor staff enters descriptive elements for your house into the system; the system selects recorded sales of similar properties (‘comparables’) and analyzes them relative to your house. The analysis results in the value estimate for your house.

Tips for Reducing Taxes

Several events might prompt you to think your real estate taxes are outrageous: your recent tax bill might be significantly higher than it was in previous years, or you might have learned that a neighbor’s tax bill is considerably lower than yours. Below are steps to ensure your tax bill is fair.

Start by studying the assessor’s description of your house. Does the description indicate more bedrooms than your property possesses or more finished area in, say, your basement? Assessors rarely have the personnel or time to inspect the interior of every property; hence, the assessor may be making incorrect assumptions about yours. Also, check the most recent sale price for your property. If you know it included items other than real estate, like furniture or vehicles, the assessor should take that into consideration.

At the same time, verify that the assessor has identified your property as residential. Commercial and industrial properties are usually assessed at a higher value than houses. Confirming this one element could result in lower taxes for you.

Assuming your property is being assessed at the correct rate, there is little you can do to change that rate. Assessor boards adopt uniform rates for all properties within their jurisdiction. Your best bet for influencing future rates is to attend your town’s public council and board of assessment meetings to protest your town’s (presumably) excessive rates. However, you should also investigate whether any special tax exemption programs apply to your property or town.

If your research suggests that your real estate taxes are steep, you can apply for tax abatement. Your local assessor’s office will have information on the abatement process, as well as the application forms required. The application will ask you to state your own property value estimate. This is the point where it will help to have professional assistance.

Keeping an Eye

Real estate taxes are a regular component of any property’s ownership costs. Understanding a building’s taxes, and ensuring those charges are fair, can result in lower expenses and enhance such property’s income-producing potential. Besides, you will gain a better understanding of how the local government views your property and how your community pays for its public improvements.

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