The Tax Cuts and Jobs Act (“TCJA”) contains a new tax incentive program that can be an important planning tool in deferring Federal income tax that arises when selling a business. 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. Proposed regulations have also been issued which detail how Opportunity Zone tax benefits are to be applied.
In general terms, a taxpayer with 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 if it is used to make an investment in qualified Opportunity Zone property within a prescribed period. An important point here is that the gain can be deferred dollar-for-dollar in connection with the qualified investment, rather than the amount of the sale that produced the taxable gain.
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 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.
Once the 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 appreciation in the value of the investment from the original acquisition date through the date of disposition.
The amount of originally deferred gain will become taxable in 2026 even if the Opportunity Zone investment has yet to be sold.
As an example, assume that a taxpayer sold his business in 2018 for $20 million, resulting in a $10 million capital gain. The taxpayer decided to invest $5 million of the proceeds in a qualified Opportunity Zone. The $5 million investment results in a deferral of recognition of $5 million 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 tax which will be deferred is $1 million.
If the taxpayer holds this investment for at least 10 years and its value increases to $8 million, the $5 million in deferred gain would be taxable in 2026. Assuming that a 20 percent capital gain tax rate continues to apply in 2026 and that the Opportunity Zone investment will now be subject to the net investment income tax of 3.8 percent (clarification from the IRS is still needed on this later component), the tax that due in 2026 would be $1,011,500 (i.e., the original deferred tax of $1 million that now becomes payable increases by $11,500).
When the investment is ultimately sold in the future for $8 million, the economic gain of $3 million ($8 million value less the $5 million original investment) will not be subject to any Federal income tax. The cumulative Federal tax on the original $5 million of deferred gain and the $3 million in appreciation works out to $1,011,500, for an effective tax rate of 12.6 percent. Not a bad outcome measured from a tax perspective.
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. Where the taxpayer’s gain flows from ownership of an investment in a pass-through entity; for example, 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). For example, a shareholder in a calendar year S corporation can make an investment within 180 days of December 31st of the year in which the gain arises, rather than a date earlier in that year when the gain may have been triggered.
So what’s the catch? The legislative justification for qualified Opportunity Zone provisions is to promote investment in distressed communities that may not otherwise attract such investments. This would suggest a higher level of care when selecting an Opportunity Zone investment to assure that it is consistent with a taxpayer’s investment benefit / risk expectations. Tax savings in the context of a bad investment is rarely a good outcome.
One mechanism to mitigate risk involves using Opportunity Zone funds, which pool funds to make multiple qualifying investments with the goal of limiting risk through diversification. Now that the IRS has issued its guidance, many investment firms, syndicators, and others are hard at work developing qualifying Opportunity Zone funds in this regard. These funds may be an appropriate option for some taxpayers, while others may prefer to have greater control by making a qualifying direct investment, such as Opportunity Zone rental property.
If you have any questions or would like to discuss whether Qualified Opportunity Zones may represent an opportunity for your or your business, please don’t hesitate to contact us.
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