Defer Taxes on Eligible Capital Gains With Opportunity Funds and Opportunity Zones
Congress created the Opportunity Zone program through Tax Cuts and Jobs Act in December 2017 to encourage private investment in economically distressed communities by providing tax incentives. The program’s key elements are Qualified Opportunity Zones (QOZs), Qualified Opportunity Funds (QOFs), and capital gains tax incentives.
What are Qualified Opportunity Zones?
The Treasury Department tasked the governors of the US states and 5 territories to identify census tracts within their jurisdictions with a poverty rate of at least 20% or a median income no more than 80% of the greater statewide median family income. Once identified, the governors submitted up to 25% of the eligible census tracts for consideration. The US Treasury reviewed the nominations and certified more than 8,700 tracts as QOZs. California currently has 879 census tracts that have been designated as QOZs. An interactive map showing California's QOZs is located at opzones.ca.gov/oz-map.
What are Qualified Opportunity Funds (QOFs)?
Investment in an Opportunity Zone must occur through a QOF. A QOF is an entity that can be organized and taxed as either a corporation, a partnership, or an LLC. To become a QOF, an eligible corporation or partnership self-certifies by filing Form 8996 with its federal income tax return.
What are the Capital Gains Tax Incentives?
An investor that sells an appreciated asset (stocks, real estate, stamp collection, etc.) realizes a capital gain, which is a taxable event. The investor can take advantage of the Opportunity Zone program by investing the realized capital gains within 180 days into a QOF. By rolling realized capital gains into a QOF, the investor can defer paying tax on the gain until the earlier of the date on which the investment in the QOF is sold or December 31, 2026.
If the investment remains in the QOF for 5 years, there is a 10% exclusion of the deferred gain. If held for 7 years, the 10% becomes 15%. Notably, if the investor holds the investment in the QOF for 10 years, the appreciation on the investment in the QOF is tax free.
Samantha sells her baseball card collection and realizes a capital gain of $100,000. She rolls the gain into a QOF within 180 days. If she keeps it in the QOF for at least 5 years, she will only pay taxes on $90,000. If she keeps it in a QOF for at least 7 years, she will pay taxes on $85,000. If Samantha stays in the fund for at least 10 years, any appreciation is tax free. So, if her $100,000 in the QOF appreciates to $500,000, Samantha keeps the $400,000 difference tax free.
Since the payment of the capital gains tax on the original transaction is deferred only until December 31, 2026, at the latest, there will be a tax due with respect to the original capital gains for all investors in the program.
QOF Property Investment Considerations
While a QOF can invest in either a QOZ property or a QOZ business, the remainder of this article offers a review of considerations regarding QOZ investments in property. To qualify, a QOF must improve the property it acquires by satisfying the substantial improvement requirement. Within 30 months of the acquisition of the property, the QOF must improve the property by spending the amount of the tax basis for the existing improvement(s) on the property plus $1.00. For example, a QOF acquires improved real property for $1 million. The land has a tax basis value of $600,000 and the improvements have a tax basis value of $400,000. To satisfy the substantial improvement requirement of the statute, the QOF must substantially improve the structure by spending at least $400,001 within 30 months of acquiring the property. Raw land, however, does not have to satisfy the substantial improvement test. As a result of the substantial improvement requirement, an appraiser should be hired to determine the value of the improvement(s) on the property at the time of the acquisition.
The 30-month substantial improvement requirement is difficult to meet, but there is an exception if the QOF plans its development activity appropriately. The working capital safe harbor allows a QOF to have an additional period of time of up to 31 months to deploy capital. In order to take advantage of the working capital safe harbor, the QOF must have a written plan identifying the financial property as property held for acquisition, construction, or substantial improvement of tangible property in the QOZ. The QOF must have a written schedule for using the working capital assets within the 31 month period. The QOF has to substantially comply with the schedule by spending the working capital assets within the 31 months of receiving the assets.
A QOF can reinvest the proceeds received by the sale or disposition of QOZ property into another QOZ property if done so within a reasonable time. The QOF has a 12-month period beginning on the date of the transaction to reinvest. Reinvestment within the 12-month does not cause the recognition of deferred gain by the investors in the QOF. The 12-month period deadline is also extendable if the failure to meet the deadline is attributable to a delay in government action.
How is this program different from a traditional 1031 Exchange?
The Opportunity Zone program differs from a traditional 1031 like-kind exchange in several ways. A 1031 exchange requires the use of all the proceeds from the sale of real property. With this new program, the participant need only use some or all of the capital gains from their sold investment (only the portion of the capital gains that are invested with a QOF qualify for the Original Gain Benefit). The amount of the principal invested in the original property can be used for other things. Participants can pocket or otherwise use the amount of the initial investment without paying capital gains tax on it. A 1031 exchange requires acquisition of “like-kind” investment (currently, only real estate will qualify).
If this article raises any questions for you, or you would like more information about this tax deferral program, feel free to contact us.