Frequently asked questions about opportunity zones
INSIGHT ARTICLE |
The Tax Cuts and Jobs Act of 2017 established so-called opportunity zones to jump-start economic growth in low-income areas around the country. The government allows any participating investor 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. That fund, in turn, must invest 90 percent of its assets in businesses or property used in one of these designated low-income communities.
Following are a list of frequently asked questions regarding the details and benefits of opportunity zones.
What is an opportunity zone?
Opportunity zones are part of a new program enacted under the TCAJ. 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 TCAJ, 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, a draft of which has been released by the IRS.
Beginning on the date of the sale that results in some capital gain, a taxpayer has 180 days to reinvest the amount of gain to be deferred in a QOF. The taxpayer will then make an election on his or her tax return to defer the gain. For example, if the taxpayer sold stock in 2018, the election would be made on the 2018 tax return.
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 the taxpayer holds the investment in the opportunity zone for five years, the taxpayer will receive a basis increase of 10 percent. If the taxpayer holds the investment for a total of seven years, then the basis increase will be 15 percent. For example, if a taxpayer elects 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 he or she 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?
Under proposed regulations, 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 his or her distributive share of the gain. If a partner makes the election, then the 180-day window begins at the close of the taxable year in which the gain is recognized. There are still many unanswered questions regarding partnership implications, which future IRS guidance is expected to address.
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 U.S. Department of the Treasury has a list on the Community Development Financial Institutions Fund website.