In December 2019, the IRS issued final regulations to provide guidance to taxpayers investing in qualified opportunity zones. A qualified opportunity zone (QOZ) is an area, provided by the 2017 Tax Cut and Jobs Act, that allows for the designation of certain low-income community census tracts to be eligible for favorable tax rules. This encourages economic growth and investment in businesses, thereby improving the lives of those living in the opportunity zone.
There are several significant tax benefits resulting from the proper investment in a QOZ, which can be shown by the following example.
Assume a taxpayer sold the stock of her business in 2019 for $20 million, resulting in a $10 million long-term capital gain. The taxpayer decides to invest $10 million of the proceeds (the taxable gain) in a QOZ. This $10 million investment results in a deferral of the capital gain.
After five years of holding this investment in the QOZ, she will be able to step-up her basis in the investment by 10 percent of the $10 million investment. If she holds the investment for another two years, she can step-up the $10 million basis by another 5 percent (please note that this additional 5 percent benefit is not available for investments made after 2019). Any deferred gain that has not been permanently excluded by either the 10 percent step-up or 5 percent step-up provisions must be recognized (tax paid) by December 31, 2026. Thus, the taxpayer must ensure that she has the cash available to pay this deferred tax.
If the taxpayer holds her investment for 10 years, there is no gain on any appreciation in the investment upon sale. Thus, if her $10 million investment is sold for $15 million after 10 years, the economic gain of $5 million is not subject to federal income tax.
Taxpayers considering taking advantage of a QOZ investment have up to 180 days from the date of the sale triggering the capital gain. The 180 day rule has a different meaning depending upon who incurs the gain. The rules are different for flow-through entities versus actual taxpayers. This tax planning idea is available for individuals, partnerships, S corporations, C corporations, trusts, and estates.
Depending upon when and how a capital gain was incurred in 2019, it may not be too late to make an investment in a qualified opportunity zone structure to defer capital gain tax and potentially eliminate tax on the appreciation of your investment.
Careful consideration should be given to such an investment. For example, what will be the capital gain tax rate in 2026 when the deferred tax is due? What is the quality of the business opportunity underlying the investment in the opportunity zone?
A tax deferred or eliminated is great tax planning, but it’s not great tax planning if the underlying investment is not a good business deal and you end up losing your investment.
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