By: Sylvester Baines and Cindy Anderson
The Tax Cuts and Jobs Act passed on Dec. 22, 2017, created one of the most significant tax deferral/savings provisions ever enacted. Known as the Investing in Opportunity Act, it is one of the least-known parts of last year’s massive tax overhaul that could be the most consequential. By tapping into the trillions of unrealized capital gains held by wealthy investors and corporations, it promises to pump a massive amount of cash into America's most impoverished communities while offering those same taxpayers a chance to erase tax obligations.
The target of this brilliant incentive is Qualified Opportunity Zones (QO Zones).
QO Zones are economically-distressed communities designated by each state. Governors were allowed to designate 25 percent of their states’ eligible census tracts as QO Zones based on economic need and desired paths of growth. A map of all QO Zones can be found at https://eig.org/opportunityzones.
What incentive does the Opportunity Act provide? Realized capital gains (short-term or long-term) can be reinvested within 180 days into QO Zones through qualified opportunity funds (QO Funds). Tax on the reinvested gain can be deferred up until Dec. 31, 2026. (If it's sold earlier, tax is recognized, or it can be rolled into another opportunity fund and remain tax-free.) In addition to deferring gains, taxpayers can reduce their recognized gain by 10 percent after holding the asset for five years, and by an additional 5 percent after holding it for seven years, ultimately only paying tax on 85 percent of the recognized gain. That’s 15 percent of the original gain permanently excluded from income inclusion.
That’s not all! The biggest benefit comes at the 10-year mark. At that point and into the future, the investor will be exempt from any gain/appreciation that accrued after the original re-investment. The QOZ investment grows tax-free, like a Roth IRA, provided it's held for at least 10 years.
A key component and the new financial product for this incentive is the qualified opportunity fund (QO Fund). A QO Fund is any investment vehicle organized as a corporation or partnership (including an LLC treated as a partnership for tax purposes) investing in QO Zones. The fund can self-certify and must hold at least 90 percent of its assets in QOZ property. QOZ property consists of QOF stock, QOF partnership interest, or QOZ business property.
Initially, there was very little guidance on how to properly take advantage of the benefits created by the Opportunity Act. As discussions about this monumental opportunity circulated, there were many questions and issues raised by professionals and taxpayers alike. Proposed regulations have recently been issued to address some of these questions.
A few highlights to consider:
- Capital gains from pass-through entities are eligible for deferral. The capital gain can be deferred at the entity or individual level. The individual investor has 180 days from Dec. 31 of the year in which the pass-through entity reports the gain to invest in an OZ Fund.
- The taxpayer may take a single capital gain transaction and elect to defer eligible gain through multiple QOZ investments.
- QOZ business property must be original use or substantially improved property. The regulations clarified substantially as improvements to the structure equal to at least 100 percent of the property’s cost basis within 30 months of acquisition. The regulations also clarified that the cost of the land associated with the purchase can be disregarded when determining this value.
- The regulations proposed a working capital safe harbor available to QO Funds allowing cash set aside specifically for the development of long-term projects as qualified property to satisfy the 90 percent test. Instead of 6 months, the fund will have 31 months to deploy designated cash.
- The original gain maintains its characteristics throughout the deferral period. For example, if the gain was determined to be a short-term capital gain at original sale, then the gain will remain short-term and taxed at ordinary tax rates when included in taxable income at the end of the deferral period.
All issues are not entirely clear yet. We are still in need of some concrete details. The Treasury Department said it is accepting public input and will issue a new iteration of the program by the end of the year.
The information that is clear is that this is an incredible opportunity (and possibly the reason that word is repeated over and over in the designations) – not only for taxpayers sitting on huge unrealized capital gains interested in tax deferral and exclusion, but also for underperforming American cities and neighborhoods getting a boost from savvy investors directing money into projects they think will succeed.
We have the experts ready to assist you as you consider your ability to capture the benefits provided by this little-known, highly advantageous Investing in Opportunity Act.
Contact Cindy Anderson at firstname.lastname@example.org or 615-690-1935 to discuss your tax advantage with qualified opportunity zones!