The Tax Cuts and Jobs Act (TCJA) includes a provision that the Secretary of the Treasury says should lead to $100 billion in capital investments in distressed areas. The provision allows taxpayers to defer tax on capital gains by investing in designated Opportunity Zones. This tax deferral is potentially “win-win,” as it decreases the investor’s current tax liability and boosts economic growth in disadvantaged areas.
The Tax Incentive in a Nutshell
The TCJA creates a new section of the Internal Revenue Code, Section 1400Z, that establishes Opportunity Zones within low-income communities. More than 8,700 communities in all 50 states, the District of Columbia, and five U.S. territories have been designated as qualified Opportunity Zones. They will retain that designation until December 31, 2028.
Investors can form private investment vehicles, known as qualified opportunity funds (QOFs), for funding development and redevelopment projects in the zones. QOFs must maintain at least 90% of their assets in qualified Opportunity Zone property, including investments in new or substantially improved commercial buildings, equipment, and multifamily complexes, as well as in qualified Opportunity Zone businesses.
QOF investors are eligible for tax benefits. They can defer short- or long-term capital gains on a sale or disposition if they reinvest the gains in a QOF. The tax is deferred until the earlier of 1) the date the fund investment is sold or exchanged or 2) December 31, 2026.
If the investment runs five years, an investor will enjoy a step-up in tax basis equal to 10% of the original gain, so the investor will owe tax on only 90% of that gain. An additional 5% in basis is added at the seven-year point, cutting the taxable portion of the original gain to 85%.
In addition to the deferral of gain, an investor is eligible for an increase in basis of the investment up to its fair market value on the date it is sold or exchanged, as described below. Thus, depending on the date of the transaction of the initial sale to be deferred and the subsequent sale of the QOF investment, the taxpayer could eliminate up to 85% of the deferred gain as well as 100% of the gain attributable to the sale of the QOF.
Rules for Investors
The IRS guidance makes it clear that only capital gains—such as those from the sale of stock or a business—qualify for tax deferral. The guidance also clarifies that an investment in a QOF must be an equity interest, including preferred stock or a partnership interest with special allocations. A debt instrument doesn’t qualify. A taxpayer can, however, use a QOF investment as collateral for a loan.
To qualify for deferral, investments in a QOF must be made during the 180-day period beginning on the date of the sale that generates the gain. For amounts deemed a gain by federal tax rules, the first day of the period generally is the date that the gain would otherwise be recognized for federal income tax purposes.
The IRS noted that the expiration of Opportunity Zone designations at the end of 2028 raises questions about QOF investments that are still held at that time. For example, can investors still make basis step-up elections after 10 years for QOF investments made in 2019 or later?
The IRS guidance preserves the ability to make the election until December 31, 2047, because the latest gain subject to deferral would be at the end of 2026—the last day of the 180-day period for that gain would be late June 2027. A taxpayer deferring such a gain would reach the 10-year holding requirement only in late June 2037. The extra 10 years is afforded to preempt situations where a taxpayer would need to dispose of a QOF investment shortly after completing such time to obtain the tax benefit, even though the disposal otherwise would be disadvantageous from a business perspective.
If an investor disposes of its entire original interest in a QOF, which normally would trigger inclusion of the deferred gain, the investor can continue the deferral by reinvesting the proceeds in a QOF within 180 days. This allows investors to escape bad deals without forfeiting the deferral benefit.
More Guidance to Come
The IRS has requested comments on several parts of the proposed regulations, suggesting they are subject to significant revision, and promising more guidance. Nonetheless, taxpayers generally may rely on these rules if they consistently apply them in their entirety.
If you have questions about the Opportunity Zone tax incentives, or would like to request a speaker on this topic for your organization or event, contact one of our PYA executives below at (800) 270-9629.
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