The Tax Cuts and Jobs Act (TCJA) of 2017 established the qualified opportunity zone program for the purpose of jump-starting economic growth in low-income areas around the country. The government allows eligible taxpayers to defer paying tax on capital gains from the sale of property in these areas if those gains are invested in a qualified opportunity fund (QOF). That fund, in turn, must invest 90 percent of its assets in businesses or property used in one of these designated low-income communities.
There continues to be interest in the creation of QOFs and the deployment of those funds in the proper areas. Investors looking to gain the benefit of any increase in their original investment basis must be in a QOF by the end of this year.
In addition to tax savings, QOFs are a great fit for the continued rise of ESG (Environmental, Social, and Governance) motivations that are attracting investors to put their money in areas of need. Once these funds have raised sufficient amounts of capital, they will be turning their focus on finding assets to purchase. Treasury extended many of the QOF deadlines in response to the pandemic, but managers need to stay on top of the new requirements to maintain good standing, particularly around the working capital safe harbors and substantial improvement period rules.
Interested in investing in a qualified opportunity zone? Following are a list of frequently asked questions regarding the details and benefits.
What is an opportunity zone?
Opportunity zones are part of a new program enacted under the TCJA. An opportunity zone is an economically distressed community as determined by specific government criteria and designated by the governor of each state. Investments in these areas, under certain conditions, may be eligible for preferential tax treatment. Under the TCJA, opportunity zones are set up to encourage long-term investments in low-income communities nationwide. Each state is allowed to nominate specific census tracts to be designated opportunity zones.
What is the benefit of investing in an opportunity zone to an investor?
Investing in an opportunity zone allows a taxpayer to defer paying tax on the gain from the sale or exchange of property. A taxpayer may pay less tax on the gain that was originally deferred, and in some cases, pay no tax on the gain from the appreciation of the opportunity zone investment, depending on the holding period.
How does one invest in an opportunity zone?
Investments in opportunity zones must be made through a qualified opportunity fund in order to be eligible for the tax benefits. A QOF can be a partnership or C corporation that certifies it is a QOF. The partnership or corporation will self-certify by completing and filing Form 8996.
The general rule is that a taxpayer has 180 days from the date of the sale that results in capital gains to invest into a QOF. The taxpayer will then make an election on their tax return to defer the gain. For example, if the taxpayer sold stock in 2021, they would have 180 days from the date of the stock sale to invest into a QOF and the election would be made on the 2021 tax return to defer the gain.
There are exceptions to this general 180-day rule that provide investors flexibility on when they can invest into a QOF to defer gains related to pass-through entities or installment sales.
The taxpayer can elect to defer as much or as little gain as they choose. There is no limit on the amount of gain that can be deferred. For example, if a taxpayer sells stock for $1.5 million with basis of $500,000, the taxpayer will have a gain of $1 million. The taxpayer can defer all the gains by investing all of it in a QOF and then making an election on a timely filed return. However, the taxpayer may defer as little of the gain as he or she chooses. The taxpayer could defer $100,000 of the gain by investing only that amount in a QOF.
The taxpayer can defer the gains until Dec. 31, 2026, provided the investment in the QOF is not sold before that date. If the investment is sold before Dec.31, 2026, the taxpayer will recognize a gain in the year of sale.
Are there any benefits other than deferral of the gain?
Yes, the taxpayer can get a basis increase on the original investment in the QOF and a potential elimination of the tax on the appreciation on his or her investment in the QOF.
If by December 31, 2026 (when the deferred gain is recognized) the taxpayer holds the investment in the opportunity zone for five years, the taxpayer will receive a basis increase of 10 percent. If by December 31, 2026 the taxpayer holds the investment for a total of seven years, then the basis increase will be 15 percent. For example, if a taxpayer elected to defer a $1 million gain in 2018 by investing in a QOF, at the end of 2023 (i.e., the five-year holding period), the taxpayer will receive a basis increase of $100,000 ($1 million x 10 percent). If the taxpayer holds the investment through the end of 2025, the taxpayer will receive a basis increase totaling $150,000 ($1 million x 15 percent). If the taxpayer has not disposed of the QOF investment at the end of 2026, then they will recognize a gain on the 2026 tax return of $850,000 ($1 million original gain less basis increase of $150,000).
Furthermore, if the taxpayer holds the investment in the QOF for 10 years, the appreciation on the sale of the QOF investment is not taxed. As noted in the above example, a taxpayer invested gain of $1 million in a QOF and held the investment for more than 10 years. After 10 years, the taxpayer sold the investment for $1.4 million, realizing a gain of $400,000. That $400,000 gain will not be taxed since the taxpayer invested in a QOF and held the investment for 10 years.
What about ordinary income from the original sale?
Qualified opportunity zone tax benefits only apply to capital gains, not to ordinary income. If a transaction produces both ordinary income and capital gains, the entire gain can still be invested in a QOZ if the taxpayer elects to do so, but only the capital gain amount will be eligible for the QOZ benefits.
How would it work for a gain recognized by a partnership?
First, a partnership may make a QOZ deferral election, in which case the incentives apply at the partnership level, and the original gain is not recognized by the partners. Alternatively, the partnership may forgo electing the QOZ deferral, in which case each partner may independently make a QOZ deferral election on their distributive share of the gain. By default, the partner’s 180-day window begins at the close of the taxable year of the partnership in which the gain is recognized. The partners may alternatively elect to have their 180 day period start on either: a) the date that the partnership sold the property which generated the capital gains or b) the original due date (not including extensions) of the partnership’s tax return.
The above also applies to other pass-through entities such as an S Corporation.
What types of businesses will qualify for inclusion in a QOF?
Many types of businesses can qualify; they range from manufacturing and distribution to real estate developments, including mixed use, retail and apartments, to name a few. In order for a business to qualify, it must meet the definition of QOZ business property, which has an original use test or a substantial improvement test.
Under the original use test, the original use of QOZ business property must begin with the QOF or a QOZ business (e.g., a newly constructed building). Property can also qualify under the substantial improvement test if during the 30-month period, beginning with the acquisition by the QOF, the basis in the property (not including any land) increases by more than the adjusted basis at the time of acquisition.
Are there any risks with a QOF investment?
Yes, there is potential economic risk or opportunity cost that should be considered before investing in a QOF. There is no guarantee that a QOF investment will earn the level of returns shown in any projections prepared by the fund developers. If a QOF investment underperforms, compared to investment of the same capital gain income in a higher growth area, then the difference in returns may be greater than the tax savings from the QOF. It would be prudent to perform some due diligence on a potential QOF investment similar to that of any other type of business acquisition.
Where can I find a list of the designated opportunity zones?
The IRS website has a list of QOZ locations by census tract. See also Notice 2018-48 and Notice 2019-42.