By: Randall A. Denha, JD, LL.M.
Alert! There’s a new tax strategy available that’s been tucked snugly into the blanket of the 2017 Tax Cuts and Jobs Act and provides significant deferral and reducing of capital gains. The law’s objective is to promote investment in qualified opportunity zones (“QOZ”). The QOZ allows taxpayers to take advantage of this new investment vehicle to help direct resources to low-income communities, known as Qualified Opportunity Zones.
What is an Opportunity Zone?
A QOZ is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. A specific population census tract in a state can become a Qualified Opportunity Zone if it is nominated by a state and approved by the Treasury. Each state is allowed to designate up to 25 percent of the low-income communities in the state as Qualified Opportunity Zones. The designation of a Qualified Opportunity Zone generally remains in effect for 10 years, ending on the close of the tenth calendar year beginning on or after the date of designation. Here is a link to a listing of QOZs for investment: https://www.cdfifund.gov/Documents/Copy%20of%20Designated%20QOZs.6.14.18.xlsx
What is the purpose of Opportunity Zones and how does it increase economic development?
QOZ’s are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities. QOZ’s are designed to spur economic development by providing tax benefits to investors.
Who Does The QOZ Benefit?
Any taxpayer who realizes capital gains and wishes to defer the U.S. tax on those gains. Subject to certain restrictions, capital gains can be deferred and reduced by investing the gains in QOZ property. In this way, QOZ may activate passive, patient capital by connecting investors to projects in low income communities.
How Long Can Gains Be Deferred?
Until Dec. 31, 2026, so investing this year will produce maximum deferral.
Taxpayers investing capital gains from the sale or exchange of property in a Qualified Opportunity Fund may take advantage of threesignificant opportunities:
- Deferral of capital gains tax from the sale or exchange of property until they sell their investments in the Qualified Opportunity Fund, or December 31, 2026, whichever is earlier,
- An increase in basis if the investment is held for more than five years, and
- Elimination of capital gains tax on appreciation of the investment held within the Qualified Opportunity Fund if it is held for 10 years or more.
As you are now aware, these three provisions significantly enhance a taxpayer’s return on investment. A “Qualified Opportunity Fund is an investment vehicle organized as a corporation or partnership for the purpose of investing in QOZ property. Opportunity Funds are private sector entities required to invest 90 percent or more of their resources in QOZ’s.
An individual investor sells 1000 shares of Google stock (purchased in 2005 for $291,000). The sale results in a capital gain of $813,000. The individual would generally owe federal capital gains tax of $193,494 (23.8%) on this sale. If the investor instead rolls his $813,000 gain into a Qualified Opportunity Fund within 180 days of the sale, recognition of the $813,000 gain is deferred until the earlier of the date that the Opportunity Fund investment is sold or exchanged, or December 31, 2026.
If the investor holds the Opportunity Fund investment for at least five years, the basis in the original investment is increased by 10% of the deferred gain. $813,000 gain multiplied by 10% = $81,300 added to basis. A sale after five years will reduce the original deferred capital gain of $813,000 to $731,700.
If the investor holds the Opportunity Fund investment for another two years (total of seven years), the basis in the original investment is increased by an additional 5%. So, a sale after seven years will reduce the original deferred capital gain of $813,000 by a total of 15% to $691,050.
If the investor holds the Opportunity Fund for a total of 10 years, all appreciation on the investment in the Fund will be excluded from tax entirely. Assume that the value of the original $813,000 has now appreciated inside the Fund to $1,125,000 at the 10-year mark. The recognized gain of $312,000 will be exempt from any capital gains tax.
Note that the investor will have to pay the deferred capital gains tax as of December 31, 2026, even if the investment in the Fund continues. The amount included in taxable income would be added to the taxpayer’s basis in the fund. So, in this case, assuming the gain rollover took place before December 31, 2019, the investor would owe capital gains tax at a 23.8% rate on $691,050 at the end of 2026 and would have to use outside funds of $164,470 to cover this liability.Based on the foregoing deadlines, a taxpayer should invest sooner rather than later in order to take advantage of the longest deferral period possible, as well as any basis increases.
What are the Mechanics?
While the deferral provisions operate similar to an IRC section 1031 like-kind exchange, the QOZ concept is actually better, as it requires reinvestment of a recognized gain. A 1031 exchange requires reinvestment of all net proceeds from a sale. The deferral period ends the earlier of when taxpayer sells its investment in the Qualified Opportunity Fund, or December 31, 2026, at which time the taxpayer must include the amount of the gain in its gross income. To defer gains, the taxpayer must invest the gains in a QOZ within 180 days of a realization event. This can be done by purchasing stock or partnership interests in businesses that are physically located in qualified zones or by investing in a QOZ fund, which pools investments in qualified zones.
The IRS has stated they will be issuing a form that will allow taxpayers to self-certify as a Qualified Opportunity Fund. After completing the form, it must be attached to the timely-filed income tax return for the tax year. In addition, an investor may make an election to defer the gain from the sale or exchange of their capital asset to an unrelated party as long as it is reinvested in a Qualified Opportunity Fund during the 180-day period, in whole or in part, when filing his or her 2018 federal income tax return in 2019.
Death During the Deferral Period
When someone passes away and leaves a QOZ property to a beneficiary, the beneficiary will not receive a step-up in basis, and realized gains will be preserved.
For example, assume your client already sold his business interests to his brother on June 1, 2018 for $11 million. He had a tax basis of $6 million, so he realized a gain of $5 million. Before Nov. 28, 2018 (within 180 days of the sale), he’ll invest the $5 million of gain in a QOZ fund. For this example, let’s assume he’ll retain that investment 11 years. Here’s what happens as the years pass: In 2019, he’ll make the appropriate elections on his income tax return. He won’t pay any capital gains tax on the 2018 sale of his business interests to his brother in 2019, because his gain will be locked up in the QOZ fund. In 2025, his $5 million of gain will be reduced by 15 percent through a basis adjustment. In 2026, he’ll recognize the remaining $4.25 million of gain on his 2026 tax return. He’ll still hold the property, and his adjusted basis will be $5 million, matching his original investment in the QOZ fund. When he finally sells the property in 2029, he’ll receive yet another tax break: His basis will be stepped up again to the fair market value on the date of sale or exchange. He’ll pay no tax on the property’s appreciation.
There’s no cap on this. A billion-dollar gain, invested in one or more qualified opportunity zones and held for five years before Dec. 31, 2026, will save the investor over $20 million in taxes.