Defer and Eliminate Taxes on Capital Gains With a Little-Used Aspect of the 2017 Tax Act

Editor’s note: In this edition of What’s Working Now, an AdvisorRADIO feature in which Horsesmouth members tell us about recent success they have had running and growing their businesses, we hear from advisor John Burke. Primarily a CPA, John has taken advantage of the Tax Cuts and Jobs Act to offer proactive tax planning, including new ways to cut capital gains taxation.

The following article includes edited excerpts of John’s interview.

New tax law causing stress

I’ve been a tax person, all things tax, for 35 years. I decided that I wanted to help people more than just by being a historian. I want to help people write the future.

This is the first year of the new tax law, and I’ve had to explain to a few people why their refund was less. Most of the time that was easy to explain. I’m seeing a lot of opportunity for the future, but also that the stress level has ratcheted up considerably. I’ve been hearing from my peers that the stress is even greater this year. A little bit of it is because this is the first year, but a lot of it is that the tax situation is so much more complex than it was in 2017. If you have a business or own any real estate, it’s a nightmare.

Taxpayers on the lower end of the income scale are going to have it much easier, while for those on the higher end things are just going to get more and more complex. It is going to make things even more complicated and expensive for taxpayers. If you’re a W-2 employee who doesn’t own an outside business or real estate, it’s going to be easier because basically itemized deductions are going away.

However, I’ve noticed the complication that if you’re in certain states, like California or Oregon, your rules for itemized deductions are different for federal than for state. That adds another level of complexity. And if you don’t pay attention, you end up paying a lot of needless state income tax that you really shouldn’t be paying. That never even crossed my mind until I started doing returns that had a $4,000 standard deduction for state taxes—even if people have $20,000 to itemize and it’s below the federal level, you’re still going to be paying state taxes that you don’t need to be paying.

Most tax professionals won’t do tax planning

The chances of a tax pro doing a thorough tax planning analysis for someone, especially during the busy season, is slim to none. I do it because I have made it my focus. It’s really a challenge for me to be looking for tax planning opportunities. If I wasn’t looking, believe me, I could just blow through and not pay any attention, just tell clients, “I’ll talk to you in June or July,” which probably wouldn’t happen. But I made a commitment that I wasn’t going to do that anymore.

Let me tell you, there have been a couple of groups that have tried to gather CPAs who are interested in tax planning, but for one reason or another they couldn’t get beyond more than 300 or 400 members. That’s indicative of the fact that it’s like pulling teeth trying to get people who are set in their ways to look at something differently.

Opportunity zones a new way to invest

One area of the new tax law that I’ve been getting involved with is opportunity zones. I went to the interactive map from the Treasury Department that shows all 8,753 zones and saw that contrary to prior programs which were focused only on neighborhoods that really needed help, when I started looking around the Portland, Oregon area there were areas designated as opportunity zones that would never be considered low income or less desirable. That’s how I first got started looking at this.

Back in early 2018, the governor of each state was asked to determine what census tracts would be considered opportunity zones in their state. It’s political, let’s put it that way.

Opportunity zones allow for some tax avoidance and a lot of tax deferral. Let’s say someone has a large realized or unrealized gain in Apple stock. In the past, there wasn’t much you could do to defer that gain, but now you can defer any kind of capital gain into existing real estate, new real estate, or a business within an opportunity zone. Investors can either buy into an existing opportunity zone or, depending on how much they plan to invest, start their own. There’s just one form to complete, and you self-certify that you’ve complied with regulations.

The first step is that you must be eligible—you have six months from the date of the sale of stocks (or other assets), or up to a year if it comes out of a pass-through entity like an S-corporation or a partnership. Then you have, not an unlimited number of places to invest, but many besides just your local area.

The benefit of investing in an opportunity zone is that eventually the gain goes away. If you purchase a property or a business inside one of these zones and hold it for five years, 10% of the original gain goes away. If you hold it another two years, another 5% of that gain goes away. And if you really like the investment and hold onto it for 10 years, then not only does 15% of your original gain go away, but 100% of the gain on the new investment goes away, and it’s never taxed.

To go back to that Apple stock, if you had just sold the shares and taken the money, you’d owe a little over 24% in federal capital gains. But if you invest it in an opportunity zone, you’re going to pay capital gains tax on only 85% of the original gain, and if you’ve complied with the regulations there will be no tax on the follow-on investment.

Join a fund or set up your own

You can go online and find many opportunity zone funds that have been created. Obviously, you’re going to pay their fees and whatever other markups they may have, particularly in real estate. The other path is if you have sufficient funds to make it worthwhile, you set up your own. You make it an S-corporation, a partnership, or any kind of pass-through. Then every year you just attach a tax return saying that you’ve complied with the regulations. Of course, the IRS can always audit that, but if I had a million dollars I’d certainly want to set up my own. I’d have to bring in a realtor and an attorney, but I’d want to avoid all of the fees if at all possible.

You can also set up a business in an opportunity zone. It can’t be a trucking company where the assets are strung out all over the country, but a regular operating business should work, as long as 90% of the assets are utilized within the opportunity zone. You can buy land. It can be residential rentals. It can be industry, commercial, any kind of real estate other than what you’re going to live in.

Like anything else, the startup is intensive, with the formation of the fund and the actual selection and purchase of the business or real estate. If it’s existing real estate, you have to spend its worth on repairs or upgrades in order to qualify for the tax deferral. Say the basis in the building is $1 million, I’d have to spend another $1 million to rehab the building in order to comply. However, if you buy new property, you don’t have that requirement. It’s like any other operating business. You have to file tax returns, do accounting, maintain the property, operate the business. It doesn’t look a whole lot different.

A lot of interest

You can tell from the Internet that there is a lot of interest in these zones. One of the challenges is that the real estate in these zones is going to be in demand. As soon as an owner knows their property is in an opportunity zone, it becomes more valuable. You’re going to have a limited supply chased by more and more money. We’ll have to wait and see how popular these things become.

With opportunity zones, any kind of capital gain can be reinvested and reap the benefits. It could be futures contracts, sale of real estate, anything that would generate capital gain. I have a client who sold a chunk of crypto currency, bitcoin, and we’re investing in an opportunity zone with some of that gain. Prior to this tax law, there was no way to defer any of those gains. We can basically take the gain from bitcoin and turn it into real estate. That’s a new one. Any asset that generates a capital gain, you can turn that into real estate or a business.

Whether or not opportunity zones are a good investment for someone depends largely on the age of the person and what they really want to do with their money. If they just want to sell real estate or stock and be done with it, great. Obviously you wouldn’t do a 1031 or an opportunity zone. On the other hand, if you’ve got a gain of $100,000 or $200,000 and you want to move onto something else, maybe you want to look at finding a really good fund that’s already set up and operating, and just pay the fees.

But when you get up to half a million or a million dollars in capital gains, you have to look at the numbers. In the state of California, that would translate into $350,000 in state and federal tax. It really starts to make sense to start an opportunity zone fund. Depending on your age and what you want to do. And other variables, of course.

The provision works on the federal level, and then some of the states do not apply it to the state taxes. It depends on the state whether or not gains are deferred in an opportunity zone. California is the big one that does not comply, and I think seven or eight other states. There are opportunity zones in California, you just can’t use this provision when doing your state tax return. Your federal taxes would be deferred, but you’d pay 10%–14% in state taxes.

A matter of education and tax planning

I am actively promoting my work with opportunity zones on my website, and any time I see a client or potential client with any kind of capital gains, I talk about it. I’ve talked to many people about it, and most aren’t even aware of opportunity zones. This provision in the law is only going to last a number of years, but it’s a matter of education and just one more part of the tax planning process. For some it might work and for some it won’t. Every situation is different.

The new tax law has given me a lot of opportunities for tax planning and education. Someone said to me, “Isn’t it common sense that this is the way it would work?” And the only thing I could say to them was, “Forget common sense; throw that out.” With the new tax law, I can run a hundred or a thousand scenarios. And every time I’m shocked at what comes out on the other end.