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.
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.
Highlights and tax benefits of Qualified Opportunity Zones (QOZ) investments
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.
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).
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.