Mark Perlberg: Okay, we are live and recording. And welcome this evening to one of my first ever presentations on a topic I haven’t really had the chance to talk and this is on qualified opportunity zones. Now, qualified opportunity zones. What we’re going to be talking about tonight is what is an opportunity zone. We’re going to talk about how a qualified opportunity zone works and then we are going to talk about the tax benefits of investing with opportunity zones. And finally we are going to compare the qualified opportunity zones to another method of saving money on capital gains tax and that is going to be the 1031 exchange and we are going to compare and see which one is better. Now first thing we’re going to talk about is the identifying the qualified opportunity zones. Basically this is considered a bipartisan effort to encourage investment into the lower income areas.
So basically what we have is both sides of Congress in addition to Sean Parker, the founder of Napster, has collaborated and came up with ways that they can create tax incentives to invest in real estate in lower income areas. What’s interesting about this is when you compare this to prior policies that maybe have encouraged segregation and isolating minorities into different neighborhoods, the qualified opportunity zones are meant to be a way to encourage growth and economic development and improve housing in these areas and that will hopefully help with desegregating neighborhoods and help encourage more opportunities and also to help these areas flourishes and the businesses flourish as well. There may be some negative consequences as well because when we say desegregation, some people may also call that same term gentrification. Also, as the property values increase, you probably will expect the tax assessment and therefore the tax liabilities for property owners, longtime property owners to increase as well.
And these neighborhoods may become a little less affordable. However, as I said, it is a bipartisan effort. So what is an opportunity zone? So the governors of all of the 50 states got together and they decided different in areas that are in low income areas and they decided which are the places that we want to determine and designate as opportunity zones that are going to provide these tax incentives to provide for real estate capital and real estate investing. Well first, so some of the criteria, the poverty rate as you can see in the slide, at least 20% of the median household income is less than 80% of the median household income of its neighbors.
Another possibility is if it’s contiguous or neighboring one of these low income areas with median household income not exceeding 125% of low income communities that are considered those qualified opportunity zones and that can only be 5% of the qualified opportunity zones. So when we think about this, this may be low income housing, but these opportunity zones are more prevalent than you would think. They are not too hard to find. One sixth of people living in the US live in opportunity zones and roughly 8,500 of 32,000 people also, I’m sorry, 32,000 census tracks are designated as opportunity zones. So on the next slide you will see a map of the different opportunity zones. They exist all over the country, including Puerto Rico. You’ll also find some in Hawaii and Alaska.
So how does it work? What is the value in these opportunity zones? So when you have the opportunity zones, the tax benefits are going to come from your capital gains in deferring and reducing them. So let’s say you have capital gains and these can be capital gains in stocks, bonds, real estate, partnership interests, business assets, all of these different types of gains can be invested instead of taxed. You can defer these capital gains by investing them into a qualified opportunity zone fund. The fund is then invested into real estate or tangible business property. So not only can you invest in real estate, but you could also invest in businesses that are located and operating in these areas. You have 180 days from the time of the sale in order to put the money into the qualified opportunity zone funds. Now these funds must substantially improve the property within 30 months of acquisition because they don’t want to have slum lords who aren’t improving and enhancing the communities that they’re investing in.
So next topic, what are the tax benefits and why is this really going to help you out if you have capital gains? Well, when you have capital gains, you can defer all the taxes on them if you roll over that portion that is taxes capital gains into the qualified opportunity zone fund. You only need to invest the gain portion to defer it. Now this compares to the 1031 where all the money in the sale has to be exchanged for an asset to defer the capital gains and depreciation with capture. You only need to defer the capital gain amount and not your basis amount. You get a partial forgiveness if you keep your money into this qualified opportunity zone fund for five years. If you hold it for another two years for a total of seven years, you’ll be forgiven for another 5% of the deferred capital gain. Meaning that whatever capital gains you are deferring, less and less of it in these two checkpoints will be deferred and just will be your basis and the property will increase without being taxed for that capital gains.
Once we get to the end of 2026, however you’re going to have to recognize this deferred capital gains as a phantom expense. So after deferring it for however many years you have it in the qualified opportunity zone, eventually you’ll have to recognize that deferred gain. Now you may not have a full seven years from now to get to that full 15% capital gain forgiveness, but we can still see another really great value in the step-up basis. So if you onto this property for 10 years your money is in the qualified opportunity zone fund for 10 years, your basis in the property will increase to market value and it will mirror the market value until you sell it. So the fantastic thing is once you sell it, you will not be taxed on any of the gain that took place that is attributable to the asset that you’ve invested in, in the qualified opportunity zone.
I mean sure you’re going to face the tax liability from the deferred capital gains from the initial investment, but anything from the appreciation on that property that you invest in will not be taxed at all. Not to mention a lot of people overlook this, the depreciation recapture will not be recognized either. So if you have a basis and you are doing cost segregation in both depreciation, you’re getting all these depreciation write-offs. Normally when you sell a property you get hit with depreciation recapture and you got to pay back all those depreciation write-offs, which can be really expensive. But with the qualified opportunity zones, your basis will increase and stay with the market value and any depreciation incur will not be recaptured when you sell a property.
So here’s an example to illustrate the tax benefits. So let’s say you purchased $1 million on January 1st, 2000, $1 million in stock. You sell the stock for $2 million in 2017. Now you can expect a $1 million of capital gains, that is to be taxed either at 15 to 20% depending on what tax bracket you’re in. That could be a pretty penny, that could be up to $200,000 in taxes. But what if you take that $1 million and you roll it into a qualified opportunity zone fund and that qualified opportunity zone fund invests in real estate or business or multiple real estate assets or businesses. Now you’re not going to pay any capital gains until that later date. Now after five years, 10% of that deferred $1 million in capital gains is forgiven. So that is $100,000 in capital gains that you will not be taxed on in the future.
So that is an estimated savings of 15 to $20,000 in capital gains tax that you have earned by holding onto the property for five years. In another seven years an additional 5% as we discussed earlier will be forgiven, meaning now an additional $50,000 of the $1 million in this case will no longer be deferred. It will be completely forgiven and that’s an additional 7.5 to $10,000 in taxes that you will save by keeping your money in this account.
Now once you get to the date of December 31st, 2026, you will have to recognize the capital gains on this investment. In this instance that is $850,000 of capital gains that was deferred that you’ll recognize. Now obviously we talked about earlier the savings that we’re going to get from the forgiveness of your capital gains. You will be taxed on the $850,000, but consider the fact that because you’re getting taxed on a later date, consider the time value of money and what you will do with your money being able to invest in other real estate assets or whatever business assets or even into other stocks and bonds and the return and the time value of money.
There’s an additional savings there that you can’t really quantify in this module. After 10 years of keeping your money in the fair market value, we’re on step seven, you get that step up basis and now your basis in the new opportunity zone is fair market value. So let’s say you sell this property after holding it for 10 years in 2028 for $2 million. You have a $1 million gain, zero taxes on that gain. So normally we would expect a long-term capital gain tax, 15 to 20% on a million dollars, that’s an extra 150 to $200,000 of taxes that you’ll not receive. Now obviously these are fantastic tax benefits, but also consider the fact that perhaps it is a successful investment, is a cash flowing investment, putting money into your pocket. I can obsess over some of these tax strategies, but we also want to make sure that this investment makes business sense and if it is managed by the right property managers and things are executed properly, you will also have a cash flowing asset with passive income.
So here are some other tax strategies and business strategies to consider with this. First, unlike the 1031, we can use all sorts of capital gains deferrals, not just for real estate to attract new investors with the tax incentives. So maybe if you live in California, try to attract some people in Silicon Valley who have vested stock options or maybe you have some people who have partnership interests are selling at a capital gains. So many other sources that are not necessarily real estate related that will see the tax benefit from this. Also plan for gain recognition. So when that date comes where you’ll no longer be able to defer that gain December, or the end of the year in 2026, plan for how you can either afford those taxes or maybe bring yourself into a lower tax bracket. Maybe if you have some capital losses you can recognize to net and offset those upcoming capital gains. You can sell those shares at a profit and they won’t be taxed if you hold it for 10 years.
And also there are other incentives that may be available for these properties like the low income and new market housing credits where you can get a dollar for dollar return in the form of a housing credit to finance the properties. Now you have less money into the investments that you need and you can attract more capitals easier and your return on an investment is substantially greater for investing in these neighborhoods. So you can combine it with all these different strategies and save a ton on taxes and really create some very powerful financial vehicles if executed properly.
So next I want to compare the qualified opportunity zone strategy to the 1031 exchange as a means for deferring capital gains tax. Now this is going to give you an idea of maybe some pros and cons. Most of the people are going to be using 1031 exchanges. Obviously they’ve been around a lot longer, but here’s a good chance to look at how they differ and advantages of each. When it comes to location, your 1031 exchanges are going to have a much more favorable form of flexibility because you aren’t going to be restricted to different zones. Access to cash, I’m going to have to give this one to the qualified opportunity zones because you only have to roll over the gain portion. Remember the prior example with the $1 million gain. If you had that stock with the $1 million gain, you could roll over just that $1 million into the qualified opportunities zone. The initial investment, your basis of one million, you can do whatever you want with it. It can come back in your pocket tax-free and you can invest it wherever you want, do whatever you want with it.
Meanwhile, with a 1031, all of the sales proceeds need to go into the next investment to defer those capital gains. Access to cash, we just talked about that one. Flexibility of capital gains and asset type. This is going to be one where you’re going to see benefits from each. So for qualified opportunity zones you can invest in real estate and in business property. Meanwhile, the 1031 exchange now can only be used to exchange real estate for real estate. One of the things that we’re also going to see is what we can defer as well, the capital gains type as we were talking about earlier, is you can use your stocks, your bonds, partnership interests, business assets, all these other items that are going to create capital gains can be deferred through the qualified opportunity zones.
You can only use real estate, you can only defer the capital gains on real estate with the 1031. When it comes to what you’re putting your money into with the investment type, you’re going to see a lot of flexibility both with the 1031, even though it’s real estate. For real estate, you can exchange a department store for a hotel or for a condo. You can exchange a farmland for a short term vacation rental on the beach. So there’s going to be a decent amount of flexibility and same with the qualified opportunity zones. It just has to be a business of real estate. When it comes to the number of deals with the 1031 exchange, you can only exchange one property for three properties maximum. With a qualified opportunity zone, you have a fund that can use your capital for an endless amount of deals and that fund can be investing in several properties or businesses and other opportunity zones. So there’s less restrictions in the amount of deals that you can use your funds on.
When it comes to timing, the qualified opportunity zone, as we talked about earlier, you have that 180 day time period from the date of sale to put your money into the qualified opportunity zone fund. With the 1031, you have the 45 days to identify up to three replacement properties and you have that 180-day period to close on the next property. When it comes to capital gains reduction, now we only see a forgiveness of capital gains with a qualified opportunity zones. With the 1031 exchange, you pretty much defer it and you can just, a lot of people will exchange it to bigger and bigger properties so they can keep on getting those depreciation write-offs and that’s a technique for 1031s. They call it swap until you drop. So as we’re going to talk in the next bullet point when it comes to your basis.
So as we know with qualified opportunity zones after the 10 years, you’re going to get that step up basis to market value. In 1031, your basis is going to continue to decrease and decrease unless you’re putting more cash into the property. However, when you die, your heirs will receive the property with a step-up at market value basis in the property. So you either wait 10 years through qualify opportunity zones to increase your basis to market value with a 1031. The only way you can do that is dying. So it’s a little bit more appealing if that’s what your goal is, if you want to go the qualified opportunity zone route.
So thanks for your time. Just some closing items. I have some next seminars coming down the pipeline and these are going to be a little more interactive, get a larger audience and connect this with other different media streams, Facebook and Instagram, live stream. Topics we are going to discuss coming down the pipeline is some more capital gains tax planning. This is really fun. I like to geek out on this stuff and there are so many other things we can do to plan for and mitigate capital gains when you look at the full financial picture of what your clients are doing. I’m working on some projects to plan for international investments into US properties and working with expats. And we’re going to talk about, for some of you who may want to consider, especially you syndicators attracting foreign investors into US real estate. We can talk about how we can structure this so the foreign investors are going to be interested in it and you can mitigate the tax liability so it is favorable for them.
Business loss, tax planning, this is a very relevant topic because a lot of people are getting hit by the coronavirus. So we’re going to be talking about ways that we can take these losses and create refunds and really optimize all the opportunities when we have losses on our books to set up for future success in tax savings. Another one is quitting your job to invest full-time or as I wrote full Tim accidentally. We’re going to talk about some strategies so you can leave the rat race and become a full-time investor and ways that you can save money on your taxes to free up capital to do that as efficiently and quickly as possible. And then we’re going to talk about turning hobbies into legitimate sources of income and write-offs and that will allow you to also maybe leave the rat race but also have some more fun, saving money on taxes and making more money.
I have some additional resources. This includes a mile in travel log, schedule C and schedule E logs within templates so you can record everything so it’ll roll into your schedule C and schedule E. We have a time log for real estate professionals and we’re going to have some prior webinars. I will be rerecording and posting to the site. So if anybody has any questions, you could type them in the chat. I know you guys are all dying to learn as much as you can on this topic. So I have several people in my network who invest in opportunity zones and if we can talk later, I’ll shoot you an email for some people in my network who have a good reputation and they can take your money and do it.
Now one of the things we want to consider, if you want to invest in an opportunity zone fund. Now what you have to consider SEC regulations, so we have reg D and reg A are the most common because these are now going to be considered securities and you have to most likely be an accredited investor or a sophisticated investor to qualify as an investor in these securities. And yes, so a qualified and to do this, you will need a, typically you will need a qualified opportunity zone fund, but if you do find a single family rental or a multifamily, you will and should be able to do this yourself with the proper planning and infrastructure. Okay. So that’s all for today. It was a great test through run. I’m going to post this to the site and continue working through some more webinars coming down the pipeline and have a lot more fun and I appreciate everybody for coming and everybody have a wonderful night and we will talk soon.