A lot of the ink spilled in the aftermath of 2017’s Tax Cuts and Jobs Act (“TCJA”) focused on the corporate tax rate reduction to 21% or the introduction of the 20% 199A deduction for passthrough entities. However, one major tax incentive has often been overlooked: Qualified Opportunity Zones (“QOZs”). Investments in QOZs present a powerful tax-saving opportunity for investors.

Under the TCJA, a new tax incentive program was introduced to the tax code in Section 1400Z to foster economic investment in distressed communities. The tax incentive centers on investments in QOZs, which are low-income census tracks nominated by States and then reviewed, certified, and designated by the Department of Treasury. Tennessee currently has 176 certified QOZs throughout the state.

What are Qualified Opportunity Zones (QO Zones)?

A Qualified Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. 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.

  • Certain designated localities qualify
  • These localities must be nominated by their state
  • The state nominations must be certified by the secretary of the U.S. Treasury

Check out EIG’s interactive map of Qualified Opportunity Zones (Explore the Map)

What’s an Opportunity Zone's purpose?

Opportunity Zone’s were added by the recently passed Tax Cuts and Jobs Act on Dec. 22, 2017, to spur economic development.

  • Opportunity Zone’s are new! No relation to prior economic incentives.
  • They are designed to encourage long-term investments in low income urban and rural communities nationwide.
  • Opportunity Zone’s motivate economic development by providing tax benefits and incentives to investors.

What are the tax benefits of an Opportunity Zone?

Through an investment vehicle known as an Opportunity Fund, Opportunity Zone’s provide for both temporary and permanent tax deferral for eligible investors.

  • Investment in an Opportunity Fund provides temporary deferral from other investments without immediately triggering recognition of those gains. The deferred gain must be recognized on the earlier of the date on which the EO investment is sold or Dec. 31, 2026.
  • Opportunity Zone’s provide permanent deferral on capital gains if the opportunity fund is held for at least 10 years. The exclusion only applies to gains accrued AFTER an investor makes his/her investment in an Opportunity Fund.
  • A qualified Opportunity Fund is a privately managed investment vehicle created as either a partnership or corporation for the purpose of investing in qualified opportunity zone property.

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.

Real Estate Investors have an opportunity for temporary and permanent tax deferral

Opportunity Zone’s provide a very tax efficient vehicle for those investors looking to reinvest their current unrealized gains in economically distressed communities and thus escape tax through temporary and/or permanent deferral.

Temporary Deferral of Capital Gains

Investors can invest capital gains from other investments into Qualified Opportunity Funds (QO Funds) without immediately triggering recognition of those gains. This deferral of capital gains works similarly to a 1031 exchange in real property, except the investor can elect to invest solely the capital gains from other investments and the gains can come from any investment, including stocks and bonds, not just from real property.

An investor can the defer capital gains on the amount of gains invested in the QO Fund until such time that the investment is sold or exchanged, or December 31, 2026, whichever is sooner. The investor would have a tax recognition event on December 31, 2026, even if the investor still holds the investment.

A QO Fund is a self-certified partnership or corporation that holds at least 90% of its assets in eligible QOZ property. Setting up a QO Fund does not require IRS certification and only requires a simple form be attached to the entity’s federal income tax return.

Free Basis Step-Up

If an investor holds the QO Fund investment for at least 5 years, then the investor receives a 10% basis step-up on the amount of the deferred capital gain invested. If the investor holds the investment for at least 7 years, then the investor receives an additional 5% basis step-up on the amount of the deferred capital gain (for a maximum total of 15%).

Gains on QOZ Investment can be Tax-Free

The final piece of good news is that any gains on the investment in the QO Fund are tax-free if the investment is held for at least 10 years. After 10 years, investors can elect to make their basis in the investment equal to the fair market value of the investment on the date of sale.

Example

On July 1, 2018, Investor A sold stocks totaling $2 million with tax basis of $1 million for capital gains of $1 million.

Within 180 days of the stock stale, Investor A decides to invest the $1 million in capital gains into a QO Fund. Investor A has no immediate taxable gain from the sale of stock and now has $1 million investment in the QO Fund.

After holding the investment for 10 years, Investor A’s investment is worth $2 million. On July 2, 2028, Investor A sells the investment for $2 million and makes the fair market value basis adjustment election.

Here are the tax consequences:

  • As of December 31, 2026, the investment was held at least 5 years, so Investor A received a 10% basis adjustment on the amount of the invested capital gains.
  • As of December 31, 2026, the investment was held at least 7 years, so Investor A received an additional 5% basis adjustment on the amount of the invested capital gains.
  • Investor A recognized $850,000 in capital gains on December 31, 2026 ($1,000,000 in capital gains invested in Qualified Opportunity Fund minus 15% basis adjustment of $150,000).
  • On July 2, 2028, Investor A does not recognize any additional gain on the QO Fund investment even though the value of his investment has increased by $1 million. ($2 million sale minus $2 million in tax basis).

Understanding tax reform and how the changes will affect your business and you as an individual can be challenging with opportunities left on the table.  Be sure you consult with a tax advisor who has deep expertise in the multifaceted law and all its nuances.

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.

For a more detailed look at Opportunity Zone options click here, or contact Jeff Talley at jtalley@lbmc.com or 615-377-4600.

View our services flyer for further details.

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.

IRS Updates

  • 4/25/19 – The IRS has issued guidance about investing in qualified opportunity zones (QOZs). It clarifies the “substantially all” requirements for the tangible business property’s holding period and use in three ways: 1) At least 70% of the property must be used in a QOZ; 2) for the holding period, tangible property must be QOZ business property for at least 90% of the qualified opportunity fund’s or QOZ business’s holding period; and 3) the partnership or corporation must be a QOZ business for at least 90% of the fund’s holding period. [REG-120186-18]

  • The Opportunity Zone tax incentive benefits were passed as part of the TCJA. The IRS has designated 8,761 communities as Opportunity Zones. Investors that make appropriate investments in the zones can defer tax on almost any capital gain, through 12/31/26. An investor must have made an election after 12/31/17 and meet other requirements.
  • In October 2018, the IRS and Treasury Department issued proposed guidance (IR-2018-206) for the new Opportunity Zone tax incentive. The proposed regulations clarify that almost all capital gains qualify for deferral. In addition to the proposed regulations, they issued an additional piece of guidance to aid taxpayers in participating in the qualified Opportunity Zone incentive. Rev. Rul. 2018-29 provides guidance for taxpayers on the “original use” requirement for land purchased after 2017 in qualified opportunity zones.
  • The IRS has added Opportunity Zone frequently asked questions (FAQs) to its website explaining the tax benefits of Opportunity Zones and how to qualify for Qualified Opportunity Fund status.