The Tax Cuts and Jobs Act (TCJA) contains a new tax incentive program that can be an important planning tool in deferring federal and perhaps state income taxes that arise when a taxpayer incurs a capital gain. The TCJA authorized each state to identify up to 25 percent of its low income communities as Opportunity Zones, which would qualify for favorable tax benefits. A list of these designated areas was issued by the U.S. Treasury last year. Two sets of proposed regulations have also been issued which detail how Opportunity Zone tax benefits and its operations are to be handled.
In general terms, a taxpayer with a taxable capital gain arising from the sale of property, which could include capital gain arising in the context of a sale of a business, can postpone federal income tax on the gain by making an investment in Qualified Opportunity Zone (QOZ) property within a prescribed period.
If the Opportunity Zone investment is held for at least five years, a tax basis adjustment occurs wherein the tax that would have been due on the original capital gain can be reduced by 10 percent. If the investment is held for at least seven years, this tax basis adjustment and related tax reduction increases to 15 percent. In order to obtain the additional five percentage point deferral, investments must be made to the QOZ by December 31, 2019.
The amount of originally deferred gain will become taxable in 2026 even if the Opportunity Zone investment has yet to be sold.
Once the QOZ investment is held for 10 years, taxpayers can make an election to step up their tax basis in the investment to eliminate any taxable gain that would otherwise arise from the appreciation in the value of the investment from the original acquisition date through the date of disposition.
As an example, assume that a taxpayer sold her business in 2019 for $20 million, resulting in a $10 million capital gain. The taxpayer decides to invest $10 million of the proceeds in a QOZ. The $10 million investment results in a deferral of the recognition of the $10 million gain. Using an assumption that a 20 percent capital gain income tax rate would have applied and that the 3.8 percent net investment income tax would not apply, the amount of federal tax which will be deferred is $2 million.
After five years of the taxpayer holding her $10 million investment in a qualified opportunity fund, she will be able to save $200,000 ($10 million gain x basis step-up of 10 percent x 20 percent tax rate). If she held the investment for an additional two years, she can save an additional $100,000. The tax on the balance of the gain is due by December 31, 2026.
However, if the $10 million investment with qualified opportunity fund is ultimately sold in the future for $15 million, the economic gain of $5 million ($15 million value less the $10 million original investment in the QOF) will not be subject to any federal income tax. The cumulative federal tax on the original $10 million of deferred gain and the $5 million in appreciation is approximately $1.7 million, for an effective tax rate of approximately 12 percent.
Taxpayers considering taking advantage of an Opportunity Zone investment have up to 180 days from the date of the sale to make a qualifying investment in Opportunity Zone property. They can do this through a Qualified Opportunity Fund. In this case, the taxpayer’s capital gain flows from ownership of an investment in a pass-through entity. For example, in a partnership or S corporation, the qualifying investment can be made by either the pass-through entity within 180 days from the date of the transaction that results in a gain or by any of the owners within 180 days of the last day of the pass-through entity’s taxable year (rather than the gain transaction date). A shareholder in a calendar year S corporation can make an investment within 180 days of December 31 of the year in which the gain arises, rather than a date earlier in that year when the gain may have actually been incurred.
This planning idea applies to individuals, partnerships, S corporations, C corporations, trusts, and estates.
Significant bi-partisan legislative support for these QOZ provisions was the key to promote investment in distressed communities that may not otherwise attract such investments. Selecting an Opportunity Zone investment must be done with care in order to assure that it is consistent with a taxpayer’s investment benefit/risk expectations.
One mechanism to mitigate risk involves using Opportunity Funds, which pool funds to make multiple qualifying investments with the goal of limiting risk through diversification. Now that the IRS has issued some of its guidance, many investment firms, syndicators, and others are working to develop qualifying Opportunity Funds. A taxpayer may also set up their own qualified fund as these funds are self-certifying.
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