Tax Alert: Qualified Opportunity Zones
Last year’s Tax Cuts and Jobs Act, H.R. 1 (“the Act”) created a federal capital gains tax deferral program through the opportunity zone statute, which is designed to attract private, long-term investments in low-income and economically distressed communities. Over 8,700 communities designated as Qualified Opportunity Zones (QOZ), located across all 50 states, territories and Washington D.C, were nominated by local governments and confirmed by the Department of Treasury (DoT) in Notice 2018-48 issued in June 2018.
The statutory language of the Act introduced the tax incentive deferring taxable gains but it did not provide important details, including the types of gains eligible for deferral, the timing and specific requirements of qualified investments, and how investors report deferred gains. On October 19, 2018, the Treasury Department released proposed regulations, a revenue ruling, and tax forms to provide additional guidance on the opportunity zone tax incentive.
How QOZ tax incentives work
Simply stated, the opportunity zone statute allows for the deferral of capital gains if some or all of the amount of the capital gain recognized is invested in a Qualified Opportunity Fund (QOF) by an eligible taxpayer. A QOF is any entity that invests in qualified opportunity zone property and is taxed as a partnership or corporation organized in any of the 50 states, US territories, or D.C. The QOF is required to hold at least 90 percent of its assets in qualified opportunity zone property.
To defer a capital gain, a taxpayer has 180 days from the date of sale or exchange of the appreciated property to invest the recognized gain in a QOF. The potential tax benefits of opportunity zone statute include:
- Deferral of tax on capital gains invested in a QOF through 2019: Any recognized capital gain invested in a QOF through December 31, 2019 may be deferred until December 31, 2026 or eliminated when an investment in a QOF is disposed. There is an opportunity for taxpayers to make multiple investments in QOFs through the statute expiration date.
- Potential to eliminate 15% to 100% of taxes for capital gains invested: Capital gains invested in a QOF are deemed to have an initial tax basis of zero. The taxpayer receives a 10% increase in tax basis if the investment is held five years and an additional 5% increase in tax basis after seven years. If an investment in a QOF is held for ten years, the taxpayer can elect to increase their tax basis in the QOF to fair market value upon disposition, which provides for a tax-free investment in the QOF. Tax is realized on the excess of the deferred gain over the basis in the QOF at the time of disposal.
- Ability to rollover gains on disposal of investments in QOF: In general, the original deferred gain must be recognized by the taxpayer upon disposition of the investment in the QOF. If a taxpayer disposes of all of an investment in a QOF, triggering tax on the deferred gain and the qualified opportunity zone property, a taxpayer can make an investment in a new QOF and rollover the deferred gain. The rollover investment must be made before December 31, 2026.
Qualified Opportunity Zone Property
The purpose of the opportunity zone statute is to incentivize investment in low-income areas of the country in need of community development and improvement. IRC Sec. 1400Z-2(d)(2) provides guidance regarding the types of assets that will be considered qualified opportunity zone property if held by a QOF. In general, qualified opportunity zone property includes the following:
- Newly issued stock held in a domestic corporation if such corporation is a qualified opportunity zone business,
- Newly issued partnership interests in a domestic partnership if such partnership is a qualified opportunity zone business, or
- Qualified opportunity zone business property.
Qualified opportunity zone business property is further defined in IRC Sec. 1400Z-2(d)(2)(D) as tangible property used in a business in a qualified opportunity zone that is either:
- Land in a qualified opportunity zone,
- A building in a qualified opportunity zone that is first used by the QOF or the qualified opportunity business,
- A building in a qualified opportunity zone that was previously used but is “substantially improved” by the QOF or qualified opportunity business,
- Equipment that was never previously used in a qualified opportunity zone, or
- Equipment that was previously used in a qualified opportunity zone but it “substantially improved” by the QOF or the qualified opportunity business.
The opportunity zone statute defines “substantial improvement,” as an amount of investment in existing tangible property by a QOF, during any 30-month period, that exceeds the adjusted basis in the property at the beginning of the 30-month period. The Revenue Ruling issued clarifies that improvements made to land are not included in the total improvements for purposes of the “substantial improvement test” and the value of land is excluded from the adjusted basis calculations.
More details on qualifying as a QOF
The new guidance also provides details on what qualifies an investment vehicle as a QOF. And a draft of Form 8996, Qualified Opportunity Fund was released alongside the guidance to demonstrate how corporations and partnerships can self-identify as a QOF by including the form with the filing of their tax return. Additional information provided includes guidelines for determining when a QOF begins, how a QOF can meet the requirements to be recognized as a qualified opportunity zone business, and what pre-existing entities may qualify as a QOF. And finally, guidance details the test required of QOFs to determine whether the entity holds the minimum threshold of assets in qualified opportunity zone property.
Considering a QOZ investment?
While the new guidance helps fill in many details, many questions are left unanswered and the Department of Treasury plans to release further guidance before the end of the year. If you’re planning on creating or investing in a QOF, we recommend consulting with an experienced tax advisor first.
The tax team at MGO is ready to assist you in navigating QOZs, QOFs, and other income tax concerns. For further guidance or to schedule a consultation, please contact us.