The Tax Cuts and Jobs Act of 2017 (“TCJA” or the “Act”) introduced new provisions and incentives for the investment in qualified opportunity zones. The provisions allow temporary deferral from inclusion in gross income for capital gains reinvested in a qualified opportunity fund and permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund so long as certain holding period requirements are met.
The Act allows for the designation of certain low-income community population census tracts as qualified opportunity zones. The designation of a population census tract as a qualified opportunity zone remains in effect for the period beginning on the date of the designation and ending at the close of the tenth calendar year beginning on or after the date of designation.
What is a Qualified Opportunity Fund?
A qualified opportunity fund is, generally, an investment vehicle organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property that holds at least 90% of its assets in said property. Qualified opportunity zone property includes any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.
The maximum amount of the deferred gain equals the amount invested in a qualified opportunity fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains. Any capital gains in excess of the maximum deferral amount are recognized and included in gross income.
Main Tax Incentives of Qualified Opportunity Zones
The provision provides two main tax incentives to encourage investment in qualified opportunity zones:
First, it allows for the temporary deferral of inclusion in gross income for any capital gain that is reinvested in a qualified opportunity fund and possible reduction of the amount of gain realized through a basis adjustment.
If the investment in the qualified opportunity zone fund is held by the taxpayer for at least five years, the basis attributable to the original gain is increased by 10 percent of the original gain. If the opportunity zone asset or investment is held by the taxpayer for at least seven years, the basis attributable the original gain is increased by an additional 5 percent for a total of 15 percent of the original gain.
As a result, 10 percent (if the investment held for 5 years) or 15 percent (if the investment held for 7 years) of the deferred capital gain is permanently excluded. The remaining deferred gain is recognized on the earlier of the date on which the qualified opportunity zone investment is disposed or December 31, 2026.
The second main tax incentive in the bill excludes from gross income the post-acquisition capital gain on investments in opportunity zone funds that are held for at least 10 years. Specifically, in the case of the sale or exchange of an investment in a qualified opportunity zone fund held for more than 10 years, at the election of the taxpayer the basis of such investment in the hands of the taxpayer shall be the fair market value of the investment at the date of such sale or exchange. Taxpayers can continue to recognize losses associated with investments in qualified opportunity zone funds as under current law.
To demonstrate the advantages of this incentive, let’s analyze the example below:
Assume taxpayer owns stock with a basis of $50,000 and sells the stocks in 2018 for $250,000. The taxpayer would realize $200,000 of capital gain in 2018. However, under the new program, the taxpayer may defer this gain and eliminate tax on future appreciation by investing the $200,000 gain in a qualified opportunity fund within 180 days of the sale. The following chart summarizes the taxpayer’s capital gain assuming the interest in the qualified opportunity fund is sold for $320,000 after 3,5,7 and 10 years:
Holding Period Step-up in the basis of Deferred Deferred gain to be recognized Increase in gain from Fund appreciation ($120,000) 3 years 0% $200,000 $120,000 5 years 10% $180,000 $120,000 7 years 15% $170,000 $120,000 10 years 15% $170,000 $0
If the taxpayer is holding its interest on December 31, 2026, they recognize $170,000 in capital gain on that date. Note, the taxpayer does not recognize any gain on the fund’s appreciation from the $200,000 initial investment to $320,000 upon sale if held 10 years.
The current list of approved opportunity zones can be found at Opportunity Zones Resources. This list will continue to be updated as more Opportunity Zones are approved.
The taxpayer may make an election to defer the gain, in whole or in part, when filing their 2018 Federal Income Tax return. Also, to become a Qualified Opportunity Fund, an eligible taxpayer self-certifies, requiring no approval or action by the IRS. To self-certify, a taxpayer merely completes a form (which will be released by the IRS) and attaches that form to the Qualified Opportunity Fund’s federal income tax return for the taxable year. The return must be filed timely, taking extensions into account.
If you have any questions on tax incentives for investment in qualified opportunity zones, please reach out to your Withum Tax Advisor or fill out the form below.