Qualified Opportunity Zones, a feature of the 2017 Tax Cuts and Jobs Act (TCJA), are rapidly taking shape and may transform economic development throughout the U.S. The objective with these zones is to incentivize investment in qualified low-income communities, known as “opportunity zones,” by allowing investors to benefit from the following:
1. Temporary deferral of inclusion in gross income of capital gains realized on the sale of capital assets when the gain is reinvested in a qualified opportunity fund;
2. An exclusion of up to 15% of the recognized capital gain in a subsequent year as a result of a step-up in basis in the opportunity zone fund Investment, and
3. Permanent exclusion of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund provided the required holding period of 10 years or more is met.
Now that you understand the significant financial and tax benefits presented by this new law, it is time to dig into the weeds so you can gain an understanding of the details.
What is a Qualified Opportunity Fund?
A qualified opportunity fund is an investment vehicle organized as a corporation or partnership to invest in qualified opportunity zones. The fund must hold at least 90 percent of its assets in Qualified Opportunity Zones.
How are qualified opportunity zones determined?
The chief executive officer of a state (including the District of Columbia) can nominate, through the Secretary of the Treasury, a limited number of opportunity zones for certification and designation. Special consideration is given to areas that:
1. Are currently the focus of mutually reinforcing state, local and private economic development initiatives to attract investment and foster startup activity;
2. Have demonstrated success in geographically targeted development programs; and
3. Have recently experienced significant layoffs due to business closures or relocations.
How does temporary deferral of inclusion in gross income tie in?
You may elect to exclude from gross income any gain on the sale or exchange of a capital asset to an unrelated party in the tax year of the sale provided the gain is reinvested in a Qualified Opportunity Zone within 180 days of the sale or exchange. Thus, all capital gains realized by an investor within 180 days before any opportunity fund reinvestment qualify for tax benefits. After receiving the reinvested capital gain income, the opportunity zone fund invests those funds into Qualified Opportunity Zone property. Qualified Opportunity Zone property consists of newly issued stock, partnership interests, or business property in a Qualified Opportunity Zone business.
When is the deferred capital gain recognized and how is it calculated?
The investor recognizes the deferred capital gain on the date which is the earlier of:
a) The sale or exchange of the Qualified Opportunity Zone Investment, or
b) December 31, 2026.
On the recognition date, the amount of the capital gain recognized is equal to:
a) The lesser of the total deferred gain OR the fair market value of the investment at the time of sale, over
b) The investor’s basis in the opportunity fund investment.
Initially, you have a zero basis in the opportunity zone investment. Your basis is increased when certain holding periods for the opportunity zone Investment are met. If the Qualified Opportunity Zone investment (such as the purchase of preferred shares in a Qualified Opportunity Zone business) is held for at least 5 years, your basis in the investment is increased by 10% of the deferred gain. If the opportunity zone investment is held for at least seven years, your basis in the investment is increased by an additional 5% of the deferred gain, for a total of 15%. Thus, you pay tax on 85% of the deferred capital gain.
What should you know about permanent exclusion of capital gains on the sale of qualified opportunity fund property?
In the case of the sale or exchange of an investment in a qualified opportunity zone fund held for more than 10 years, you can elect for the tax basis in the investment to be equal to its fair market value on the date of its sale or exchange, which eliminates tax on the appreciation of the investment.
The rollover of the capital gain into an opportunity zone must occur before December 31, 2026. Therefore, the sooner you invest the capital gains into an opportunity fund, the better. With the recent stock market boom resulting in a stockpile of unrealized capital wealth—over $6 trillion as of December 31, 2017- many investors could maximize their benefits by investing in an opportunity zone fund. The provisions regarding Qualified Opportunity Zone investments are complex. For more information on how you can benefit from the incentivized Qualified Opportunity Zone development, contact your experienced Friedman professional.