Executive Summary:

  • Qualified Opportunity Zone Funds were a creation of the Tax Cuts and Jobs Act passed in December of 2017 and offer investors significant tax savings opportunities.
  • Investors can defer paying tax on currently taxable capital gains and eliminate portions of their deferred gains over a 5-7 year holding period.
  • The appreciation of Opportunity Fund investments can be tax free if sold following a 10-year holding period.
  • Final Regulations issued in December provide investor-friendly provisions around the types of capital gains that can be deferred and the timeline for investment.

One of the provisions of the 2017 Tax Cuts and Jobs Act included the Investing in Opportunity Act, which created a unique investment option that would allow investors to defer capital gains and help to revitalize low-income areas. The IRS first provided proposed guidance on this Act in October of 2018, and it was a step in the right direction. Another round of proposed regulations was released in April of 2019. While these regulations have been helpful in understanding how this new law would be applied, the guidance was somewhat vague and left many unanswered questions for potential investors, while also creating some new concerns. However, in December, the Treasury Department released final regulations, giving much needed clarity to the Opportunity Zone rules with hopes that investors will now be more willing to make the leap into a Qualified Opportunity Fund.

While a much longer article would be required to cover the important criteria for setting up a Qualified Opportunity Fund or a business in an Opportunity Zone that adheres to these regulations, this article will focus on important details an investor should be aware of.  Before we get to the revisions in the final regulations, let’s cover the basics of the program.

What is A Qualified Opportunity Zone?

Qualified Opportunity Zones (QOZ) are low-income communities that have been designated by each state’s governor for tax-advantaged investment by a Qualified Opportunity Fund (QOF). Nearly 12% of the United States has been designated as a QOZ. There are 176 census tracts in Tennessee that have been selected as QOZs based on the determined criteria, and they will retain their QOZ status for 10 years. The intent is to incentivize investors to defer, and potentially eliminate, a portion of their capital gains depending on the length of their investment, while at the same time revitalizing economically distressed areas around the country.

How Does the Investment Work?

After selling an investment and incurring a capital gain, an investor has a 180-day period to reinvest funds into a Qualified Opportunity Fund (QOF). A capital gain that would otherwise be taxable outside of the QOF investment is the key entry point to the tax incentives offered by the Opportunity Zone rules.  Without a capital gain to defer, the tax incentives are not available.

A QOF is an investment vehicle that can either be organized as a partnership or a corporation with the purpose of investing in a QOZ. At least 90% of the QOF’s assets must consist of QOZ property, which can be stock or a partnership interest in a business located in a QOZ, or QOZ business property. QOZ property must either be original use to the QOF or substantially improved by the QOF. There are numerous rules and guidelines around how a QOF is structured, what assets it owns, and what assets it cannot own. For the purpose of this article, we focus on the rules for an investor in a QOF meeting all the relevant criteria.

Why Should You Invest in a Qualified Opportunity Fund?

There are three tax incentives for someone that invests in a QOF:

  1. Deferral of tax on otherwise taxable capital gains
  2. Step up in tax basis on the deferred gain
  3. Permanent exclusion of taxable gain on investment appreciation

The first incentive, a deferral of tax, allows for an investor to temporarily defer the gain that would have been recognized in the current period by reinvesting into a QOF. The original gain will be deferred until the investment is sold or December 31, 2026, whichever occurs first.

The second tax incentive is an elimination of a portion of the deferred gain if certain holding periods are met before the 12/31/2026 deadline. An investor holding their QOF investment for five years receives a 10% basis step-up (or taxable gain elimination). At a holding period of seven years, another 5% basis step-up is available, creating a maximum possible gain elimination of 15%. To reiterate, the holding period of the QOF investment must meet these timeline requirements prior to 12/31/2026 in order to qualify for these basis step-ups.

A third, and potentially largest, tax incentive is the complete elimination on all capital gain on appreciation if the asset is sold following a 10-year holding period.

There are two important distinctions to be made regarding these tax incentives:

  1. Unlike a 1031 exchange where the actual funds from a capital sale must be held by an intermediary and reinvested in order to qualify for favorable tax treatment, there is no tracking of actual dollars to be invested in a QOF. Any capital gain can be deferred as long as dollars are invested in a QOF within the 180-day reinvestment period.
  2. An investor in a QOF will pay tax on the deferred gain. While they may qualify for basis step-ups during the deferral period, every taxpayer investing in a QOF will pay tax on at least 85% of their deferred gain by 12/31/2026. Assuming the QOF investment is held 10 years or more, the 12/31/2026 tax payment on the deferred gain will be the last applicable tax on the QOF investment, no matter how much it appreciates.

Highlights of the Final Regulations

There are several key distinctions that were made in the final regulations that are important to QOF investors:

How is the 180-day Reinvestment Period Impacted by Capital Gains from a Flow-through Entity?

In order to qualify, a capital gain must be reinvested in a QOF within 180 days. For an individual selling a share of publicly traded stock, the start of that 180-day window is easy to determine. It begins on the date the sale occurs and the capital gain is incurred.

But what if an investor incurs a capital gain through a partnership investment? In some cases, the investor may not be aware of the capital gain that will be taxed to them until their receive their K-1, likely long after the event creating the capital gain took place. This was considered by the IRS, and relief was provided in the final regulations. An investor who is deferring capital gain from a flow-through entity has 180 days from any of the following:

  1. The date the flow-through entity incurred the gain,
  2. The final day of the flow-through entity’s tax year (December 31 for a calendar year entity), or
  3. The original due date of the flow-through entity’s tax return, not including extensions.

Based on these rules, the maximum amount of time a taxpayer has to reinvest capital gains reported to them by a partnership would be 180 days from March 15 (partnership tax return due date) or September 11.

Are Section 1231 Gains Eligible for Investment, and When?

The regulations are clear that capital gains arising from ANY source (that is not a related party) are eligible for the tax incentives when invested within the prescribed timeline. That includes Section 1231 gains, which arise from the sale of business assets, such as rental real estate, and are treated as capital gains.

The previously proposed regulations created much concern about the deferral of Section 1231 gains and the timing of investment. Because gains from Section 1231 assets must be netted against losses incurred from similar transactions to determine their ultimate taxability, the proposed regulations dictated that investors were required to wait until December 31 each year before their gains from 1231 assets were eligible for reinvestment, after they had been netted against other losses. Fortunately for investors, the final regulations removed the delay. Gross 1231 gains are eligible for deferral when incurred, and there is no requirement to wait until the end of the year to invest. This gives investors a bigger time window and the potential for more gain to invest and tax to defer.

Are Capital Gains Related to Installment Sales Eligible?

One limitation on capital gains that are eligible for deferral under the QOF rules is that they are incurred by the taxpayer after December 31, 2017. One question left unanswered by the two previous rounds of proposed regulations was how that rule applied to installment payments received after 12/31/17, but that originated from installment agreements entered into prior to that date. The final regulations offered another taxpayer-friendly answer. Under the QOF rules, each installment payment carries with it eligible gain, and the option of its own 180-day investment window. So even if the initial sale giving rise to the installment agreement originated before 2018, each payment received is considered a new occurrence of capital gain which can be eligible for deferral. Investors also have the option of two choices when it comes to the eligible investment period for installment sale gain: the 180-day window for investment can begin on the date of each installment payment during the year, or investors can opt to use December 31 of the tax year to begin the 180-day window for all the installment payments received during the year. This gives the investor options with which to maximize their investment and tax deferral.

As with nearly all areas of tax law, there are many nuances and complications to be aware of when considering an investment into a Qualified Opportunity Fund. While there are significant tax incentives available, planning with tax and investment advisors will help ensure the benefits are maximized without creating unintended consequences.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.