by Art Wiederman, CPA, Partner
As part of the Tax Cuts and Jobs Act of 2017, Congress included in the new law a provision that received little publicity at the time the law passed, but is now gaining traction. It can be a great help for dentists who sell any assets (including goodwill) that generate short or long-term capital gain.
The law is very complex and there are still questions that need clarification from the Treasury Department, but here is how it works…
The Federal Government has designated approximately 8,000 areas all over the United States in economically distressed areas. By investing in a Qualified Opportunity Zone Fund (QOZF), which is either a partnership or corporation that is self-certified to meet the government’s requirements and owns a business or businesses in one of these areas, you can defer and partially eliminate a capital gain you might generate by selling a capital asset.
Say for example you sell any capital asset that generates a capital gain, you can invest that gain into a QOZF within 180 days of the sale. This garners you the following benefits:
- The gain on the sale of the asset is not taxed on your tax return for the year of the sale, and
- The income is deferred to the earlier of:
- the date you sell your investment in the fund
- December 31, 2026
- If you hold the investment for 5 years (before the end of the deferred period), the government allows you to permanently eliminate 10% of the gain when you sell the investment in the fund, and if you hold it for 7 years, you get to eliminate another 5% of the gain permanently. However, since the deferral period ends on December 31, 2026, only the 5 year benefit is available for any new investments made before the end of 2021.
- In addition, any gain on your investment in the fund that you earn after you invest in the fund can be permanently eliminated if you hold the investment in the fund for over 10 years.
Long-term capital gains are on capital assets held more than one year. They receive preferential tax treatment and are taxed at either 15%, 20% or in some cases 0%. Short-term capital gains are gains on capital assets held one year or less. They are taxed at ordinary income tax rates that go as high as 37%. The type of gain going into the QOZF (i.e. short or long-term) will be the type of gain recognized at the end of the deferral period.
The QOZF program can be used for the sale of:
- Personal goodwill on the sale of a dental practice
- Mutual funds
- Real estate (if you do not wish to participate in a Section 1031 exchange and want to take the basis portion of the gain off of the table, which causes issues with a 1031 exchange)
- Capital gains portion, if any, on the sale of equipment, furnishings and computers.
You cannot invest the gain on any recaptured depreciation, just the pure capital gains portion of the gain.
Here is an example of how this works. Let’s say 20 years ago you purchased Apple stock with a cost basis of $50,000. Today that stock is worth $1,050,000 so you have a gain in the shares of $1,000,000. If you sell the shares you recognize and realize a gain of $1,000,000 and pay, depending on your tax situation, between $150,000 and $200,000 in federal income tax on the gain.
Assume that you sell the shares and immediately invest the gain portion (that is the $1,000,000 as you can keep the $50,000 and take it off the table) into a Qualified Opportunity Zone Fund before the end of 2019. Also, assume you are going to hold onto the fund for many years.
- In 2019, you do not pay any current federal income tax on the $1,000,000 gain.
- In 2026 you will realize and recognize the gain on the Apple stock and report it as a long-term capital gain assuming you have held the fund until 2026.
However, since you held the investment for the five year period before December 31, 2026, you only report 90% of the gain, so you permanently eliminate $100,000 of the gain. You will pay capital gains tax at whatever the capital gains tax rate is in 2026. The capital gains tax rate has been in the 15-20% range for over 40 years, so while it might go up before 2026, it is not likely to go up significantly.
Now assume in 2039 your investment is worth $1.8 million. This means it has appreciated by $800,000 from the initial purchase in 2020. If you hold it for at least 10 years after originally buying the investment in the Opportunity Fund and sell it before the end of 2047, then the entire $800,000 gain is permanently eliminated.
You can also set up your own opportunity fund and choose your own properties and businesses to invest in.
Please be aware that if you choose to invest in the many different opportunity funds that are being formed, due to this law that you must do your due diligence on the fund and its promoters. While these tax benefits are very real and can save you money, if you lose your gain in a bad fund, all is for naught. Please give us a call if you would like more information about this topic.