Harold J. Funt, Esquire has recently become a member of the Bethlehem Rotary Club. He looks forward to participating in community service projects and events.
As 2014 begins it is a good time to look back at some of the important federal tax developments in 2013 and their impact on the new year and beyond. Some of these developments were anticipated while others were surprises, but for the most part the developments allow for tax planning opportunities.
Tax legislation. 2014 began in a very different budgetary and fiscal climate in Washington when compared to the same time last year. At the end of 2012, lawmakers were in tough negotiations over the fiscal cliff. The result was the American Taxpayer Relief Act of 2012 (ATRA), which finally passed Congress on January 1, 2013. The new law extended permanently the Bush-era tax cuts for lower and moderate income taxpayers, including reduced income tax brackets, marriage penalty relief, some education incentives, and much more. ATRA also increased taxes on higher income individuals by restoring the 39.6 percent tax bracket and revising other provisions. These and other changes made by ATRA are reflected on 2013 tax returns to be filed in 2014.
Extenders. Although ATRA resolved uncertainty about the Bush-era tax cuts, it did not make permanent many other temporary incentives. After 2013, a host of temporary incentives, known as tax extenders, expired. In some cases, for example transit benefits, taxpayers feel the effects immediately. In other cases, the impact of the expiration of these incentives will not be felt until taxpayers file 2014 tax returns in 2015. This time lag gives Congress time to extend the expired incentives, including the state and local sales tax deduction, research tax credit, higher education tuition deduction, and many more, should it be so inclined.
Tax reform. Action on the extenders could be linked to tax reform. During 2013, the leaders of the House and Senate tax writing committees undertook a nationwide campaign to drum up support for tax reform. The lawmakers visited a number of cities and highlighted proposals to simplify the Tax Code. Late in 2013, the Senate Finance Committee (SFC) released legislative language proposing changes in depreciation, the international tax rules and tax administration. However, it is unclear if the Senate, or the House, will give these proposals serious consideration in 2014 since the chief proponent of tax reform, SFC Chair Max Baucus, D-Montana, has announced his retirement from Congress.
Affordable Care Act. The Affordable Care Act (otherwise known as ObamaCare) continued to generate new rules, regulations and controversies in 2013. The Obama administration surprised many observers with a one-year delay in the so-called employer mandate. However, the individual mandate, which generally requires individuals to carry minimum essential health coverage or pay a penalty unless exempt, took effect as scheduled on January 1, 2014. Some individuals whose existing policies were cancelled because they did not meet new standards under the Affordable Care Act may be eligible for a hardship exemption to the penalty. The Affordable Care Act’s Marketplaces experienced a rocky opening but as of early 2014, the White House reported that enrollment numbers were climbing.
New Medicare taxes. The Affordable Care Act is much more than Marketplaces and health insurance delivery and reform. The Affordable Care Act also created the Net Investment Income Tax (NIIT), which some individuals may be surprised to find they owe when they file their 2013 tax returns. The IRS has issued final and proposed regulations that provide guidance on the general application of the NIIT and the computation of net investment income (NII). This tax, which became effective January 1, 2013, generally affects individuals, estates and trusts with income above certain threshold amounts. The NIIT does not apply to nonresident aliens. This tax is subject to estimated tax rules and is reported on Form 1040 for individuals and Form 1041 for estates and trusts. It is not required to be withheld from wages.
The 3.8 Percent NII Tax
Individuals. For tax years beginning after December 31, 2012, the NIITon individuals equals 3.8 percent of the lesser of:
1. net investment income for the tax year, or
2. the excess, if any, of
i. the individual’s modified adjusted gross income (MAGI) for the tax year, over
ii. the threshold amount.
For purposes of the NIIT computation, MAGI is defined as adjusted gross income before the foreign earned income exclusion. The threshold amount is equal to $250,000 in the case of a taxpayer filing a joint return or a surviving spouse; $125,000 in the case of a married taxpayer filing a separate return; and $200,000 in any other case. Although you may have heard that the NIIT only impacts higher-income individuals, this is not completely accurate. Married couples with two incomes need to be aware of the NIIT. These amounts are not indexed for inflation. Consequently, the number of affected taxpayers is expected to increase over time.
Trusts and Estates. Trusts and estates are subject to the NIIT on the lesser of (i) undistributed net investment income, or (ii) the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins ($11,950 for 2013 and $12,150 for 2014). Unlike the individual threshold amounts, the threshold amount used for estates and trusts is adjusted for inflation because the threshold is tied to the highest tax bracket. Nevertheless, the amount is far less than the lowest threshold amount for individuals ($125,000 for married filing separately). Therefore, trusts and estates should consider distributing investment income, especially if one or more beneficiaries would not otherwise be subject to NIIT because of their threshold amount.
The NIIT does not apply to certain tax-exempt trusts and grantor trusts. Special NII computational rules apply for electing small business trusts and charitable remainder trusts.
Net Investment Income (NII) defined. The final regulations provide guidance on the calculation of NII subject to the 3.8 percent tax. In general, NII is the sum of:
1. gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business;
2. other gross income derived from any trade or business that is a passive activity with respect to the taxpayer, or the trade or business of trading in financial instruments or commodities; and
3. net gain attributable to the disposition of property, other than property held in a trade or business.
1. deductions properly allocable to such gross income or net gain.
The three categories of NII cast a wide net over many types of income, including income from interest, dividends, and royalties, along with income from a passive trade or business and income attributable to an investment of working capital. As with all taxes, there are exceptions to various types of income. Every individual’s potential liability for the NIIT is unique and no one formula or strategy exists to plan for the NII.
The 2012 proposed regulations raised many questions about the NIIT, especially on how it would apply to certain types of income. Many taxpayers and tax professionals asked the IRS to list in the final regulations income items that would be excluded from the calculation of NII. However, the final regulations do not include such a list.
The IRS did attempt to answers questions about certain types of income. The final regulations explain that in certain circumstances rental of a single property may require regular and continuous involvement for NII purposes but under criteria not as rigid as under the 2012 proposed rules. The final regulations, however, do not give a bright-line test to determine when a rental activity would fall within the reach of the NIIT. The IRS also rejected suggestions that the rental income of a real estate professional should be excluded from NII, but the IRS did create a safe harbor for real estate professionals. The final regulations also describe portfolio income, income from annuities, self-charged interest, and more. Many of these changes are taxpayer friendly, particularly when measured against the 2012 proposed regulations.
NIIT may reach working capital. The 2012 proposed regulations referred to working capital as capital that may not be necessary for the immediate conduct of a trade or business. Working capital is generally invested in short-term income producing assets. As with other topics, the IRS declined to give a comprehensive definition of working capital in the final regulations, explaining that it would be too complex.
Generally, deductions from passive trade or business activities, to the extent they exceed income from all passive activities (exclusive of portfolio income), may not be deducted against other income. If a taxpayer’s original grouping was inappropriate (or there are other circumstances), the taxpayer must regroup the activities. The final regulations discuss regrouping in light of the NIIT and provide special rules for regrouping, including a valuable one-time election to regroup for NIIT purposes that will also apply for passive activity loss purposes.
When Congress created the NIIT, it specifically made an exception for certain types of retirement income. This exclusion applies to qualified retirement plans and annuity plans, tax-sheltered annuities, traditional and Roth IRAs, and deferred compensation plans under Code Sec. 457(b) plans. The final regulations clarify this important exclusion.
At the same time the IRS issued the final NII regulations, it also issued new proposed regulations on the calculation of NII regarding certain types of property. These proposed regulations were intended to clarify earlier proposed regulations. In particular, the IRS gave guidance on the sale or other transfers of pass-through interests and provided an optional simplified method to determine the amount of NIIT that would be due.
The NIIT as briefly described above is potentially very far reaching. Strategic planning to minimize NIIT liability is essential. Until the final regulations were published, many areas were unclear. Some areas are still in need of clarification as the IRS explained in the proposed regulations. The IRS also left open the door to issuing more NII guidance in the future.
Health FSAs. The IRS announced in late 2013 a decidedly pro-taxpayer change to a popular health care benefit. At the plan sponsor’s option, employees participating in health flexible spending arrangements (health FSAs) will be allowed to carry over, instead of forfeiting, up to $500 of unused amounts remaining at year-end. Plan sponsors now have the choice of either allowing employees a carryover of up to $500 or giving employees a grace period of up to 2 ½ months. However, plan sponsors cannot offer both.
Same-sex marriage and domestic partners. The IRS recently issued much-anticipated guidance on same-sex marriages and federal taxes following the Supreme Court’s June 26, 2013 decision in United States v. E.S. Windsor, 570 U.S. 12 (2013), which struck down Section 3 of the Defense of Marriage Act (DOMA). For federal tax purposes, the IRS announced a general rule recognizing a marriage of same-sex individuals that was validly entered into in a domestic or foreign jurisdiction whose laws authorize same-sex marriage even if the couple resides in a jurisdiction that does not recognize same-sex marriage. The IRS guidance answers many questions and also opens many tax planning opportunities previously unavailable to married same-sex couples. The IRS also reminded domestic partners and individuals in civil unions that they are not married for federal tax purposes. The IRS is expected to issue more guidance for individuals as the 2014 filing season approaches and for employers and retirement plans. Our office will keep you posted on developments.
Section 3 of DOMA defined marriage as only a legal union between one man and one woman as husband and wife. Because of Section 3 of DOMA, the federal government, including the IRS, refused to recognize same-sex couples as married. Same-sex couples could not file their federal income tax returns as married filing jointly (or separately), and could not claim certain tax benefits based on joint filing status, along with other limitations.
Windsor involved one of these tax benefits, the federal estate tax marital deduction which is one of the primary deductions for the estate of a married decedent. All property that is included in the gross estate and passes to the surviving spouse is eligible for the marital deduction. In Windsor, the IRS did not recognize the same-sex couple’s marriage (they had been married in Canada). As a result, the surviving spouse could not claim the estate tax marital deduction. The estate paid over $300,000 in estate taxes and the surviving spouse filed a refund claim. The dispute made its way to the Supreme Court.
The Supreme Court held Section 3 of DOMA was unconstitutional. Writing for the five-justice majority, Justice Anthony Kennedy explained that “DOMA forces same-sex couples to live as married for the purpose of state law but unmarried for the purpose of federal law…” Immediately after the Supreme Court handed down its decision, President Obama directed all federal agencies, including the IRS, to implement the ruling.
Place of celebration of marriage
After the Supreme Court’s decision in Windsor, the IRS effectively had two choices: it could take a place of domicile approach or a place of celebration approach to same-sex marriage. The IRS chose a place of celebration approach. This means, in a nutshell, that the IRS is recognizing same-sex marriages nationwide regardless of where the same-sex couple resides (in a jurisdiction that recognizes same-sex marriage or in a jurisdiction that does not). However, the IRS ruling does not apply to domestic partners, civil unions and other formal relationships recognized under state law.
For example, Aiden and Jacob marry in Vermont, a state that recognizes same-sex marriage, on August 28, 2010. Aiden and Jacob reside in Vermont until early 2013. Jacob accepts a job in Florida, a state that currently does not recognize same-sex marriage, and they relocate to Florida in March, 2013. Under the place of celebration approach, the IRS recognizes Aiden and Jacob as a married couple for federal tax purposes even though they reside in a state that does not recognize their marriage.
Filing original and amended returns
For many married same-sex couples, the first question that comes to mind is when to file their federal income tax returns as married filing jointly (or married filing separately). Legally married same-sex couples generally must file their 2013 tax returns (and all subsequent years) using married filing jointly or married filing separately filing status.
For prior years, the rules are more complicated. For 2012 and all prior years, same-sex spouses who file an original tax return on or after September 16, 2013 generally must file using a married filing separately or jointly filing status. For 2012, same-sex spouses who filed their tax return before September 16, 2013, may choose (but are not required) to amend their returns to file using married filing separately or jointly filing status. For 2011 and earlier, same-sex spouses who filed their tax returns timely may choose (but are not required) to amend their federal tax returns to file using married filing separately or jointly filing status if the period of limitations for amending the return has not expired.
Generally, a taxpayer may file a claim for refund for three years from the date the return was filed or two years from the date the tax was paid, whichever is later. The limitations period on open tax years may be extended by agreement or through a protective refund claim. Some same-sex married couples may have filed protective claims with the IRS using married filing jointly status to keep open the statute of limitations on earlier years.
Keep in mind that the benefits of filing a joint return may not always be greater than filing separately as unmarried individuals. This is known as the marriage penalty and is a factor for many opposite-sex married couples and same-sex married couples.
Health insurance and benefits
Because of Section 3 of DOMA, employers that allowed an employee to add his or her same-sex spouse to their health plan needed to impute income to the employee for federal income tax purposes equal to the fair market value of health coverage provided to the same-sex spouse. If the same-sex spouse qualified as a dependent, this rule did not apply. DOMA also precluded same-sex couples from enjoying the same benefits of cafeteria plans, including flexible heath spending accounts, health savings accounts and health reimbursement arrangements available to opposite-sex married couples. In its guidance, the IRS explained that if an employer provided health coverage for an employee’s same-sex spouse and included the value of that coverage in the employee’s gross income, the employee may file an amended return (for open tax years) reflecting the employee’s status as a married individual to recover federal income tax paid on the value of the health coverage of the employee’s spouse.
For example, ABC Co. sponsors a group health plan covering eligible employees and their dependents and spouses (including same-sex spouses). Fifty percent of the cost of health coverage elected by employees is paid by ABC Co. Sophie, who is an employee of ABC Co., was married to Mia at all times during 2012. Sophie elected coverage for Mia through the group health plan beginning January 1, 2012. The value of the employer-funded portion of Mia’s health coverage was $250 per month. Sophie’s Form W-2 for 2012 included $3,000 ($250 per month × 12 months) of income reflecting the value of employer-funded health coverage provided to Mia. Sophie may file an amended return for 2012 excluding the value of Mia’s employer-funded health coverage ($3,000) from gross income.
The IRS also explained that employers may claim a refund for Social Security and Medicare taxes paid on the benefits if the period for filing a refund claim is open. The IRS intends to issue more guidance for employers. However, claims for refunds of over-withheld income tax for prior years cannot be made by employers. The employee may file for any refund of income tax due for prior years on an amended return if the limitations period is open.
The Windsor decision significantly impacts retirement plans. The IRS explained in its guidance that a qualified retirement plan must treat a same-sex spouse as a spouse for purposes of satisfying the federal tax laws relating to qualified retirement plans. The plan must recognize a same-sex marriage that was validly entered into in a jurisdiction whose laws authorize the marriage, even if the married couple lives in a domestic or foreign jurisdiction that does not recognize the validity of same-sex marriages. More guidance about plan amendments and the application of Windsor to the period before September 16, 2013, is expected from the IRS.
As an example, if Plan A is a qualified defined benefit plan that is maintained by ABC Co., and ABC Co. operates only in a state that does not recognize same-sex marriages, then Plan A must treat a participant who is married to a spouse of the same sex under the laws of a different jurisdiction as married for purposes of applying the qualification requirements that relate to spouses.
Patchwork of laws
The Supreme Court did not strike down Section 2 of DOMA, which permits states to refuse to recognize same-sex marriages recognized in other states. The result is a patchwork of laws on same-sex marriage across the United States. As of December 19, 2013, the following states recognize same-sex marriage: California, Connecticut, Delaware, Hawaii, Illinois (effective June 1, 2014), Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Rhode Island, Vermont and Washington. The District of Columbia also recognizes same-sex marriage. A number of legal challenges are also underway in several states, including Pennsylvania, Utah and Virginia.
Repair regulations. In September, the IRS issued final regulations on the treatment of amounts paid to acquire, produce, or improve tangible property. The complex regulations reach nearly every type of taxpayer. Their complexity should not be a barrier to taking advantage of some of the taxpayer-friendly provisions. For example, the final regulations include a de minimis safe harbor, a safe harbor for small taxpayers to assist them in applying the general rules for improvements to buildings, and more.
Foreign compliance activities. In 2014, foreign financial institutions will have new reporting obligations under the Foreign Account Tax Compliance Act (FATCA). FATCA, its supporters argue, will significantly boost taxpayer compliance. Its detractors counter that the law is too complex and sweeps in its reach taxpayers who have no intention to purposefully evade U.S. taxation. Along with FATCA, the U.S. has been expanding its tax treaties and information agreements with foreign jurisdictions to encourage greater transparency. This trend is likely to continue in 2014.
Mileage rates. The optional business standard mileage rate drops slightly for 2014 to 56 cents-per-mile (compared to 56.5 cents-per-mile for 2013). The IRS attributed the reduction to generally lower vehicle maintenance costs, including the price of fuel. For 2014, the depreciation component of the business standard mileage rate is 22 cents-per mile. This represents a one-cent decrease from the depreciation component for the 2013 business standard mileage rate. Similarly, the optional standard mileage rate for qualified medical and moving expenses will also decrease from 24 cents-per-mile for 2013 to 23.5 cents-per-mile for 2014. However, the 14 cents-per-mile rate for charitable miles driven is set by statute and is unchanged for 2014.
Estate Taxation. ATRA also addressed federal estate tax matters. For persons dying after December 31, 2012, the maximum estate tax rate is 40 percent with a $5,000,000 exclusion (inflation adjusted to $5,250,000 for 2013, and $5,340,000 for 2014). ATRA also makes permanent “portability” between spouses. Portability allows the estate of a decedent who is survived by a spouse to make a portability election to permit the surviving spouse to apply the decedent’s unused exclusion (the deceased spousal unused exclusion amount (DSUE)) to the surviving spouse’s own transfers during life and at death. Effectively, portability allows both spouses to transfer a combined estate of double the usual $5 million exclusion (plus the inflation adjustment) estate-tax free ($10,500,000 for 2013 and $10,680,000 for 2014). Additionally, ATRA makes permanent a number of other estate tax provisions, which were scheduled to expire after 2012, such as provisions affecting qualified conservation easements, qualified family-owned business interests (QFOBIs), the installment payment of estate tax for closely-held businesses for purposes of the estate tax, and repeal of the five percent surtax on estates larger than $10 million.
MFDD tax, estate planning and elder law attorneys are available to answer questions you might have regarding income and estate tax matters. Contact us using the form at the right, or call 610.882.9800.
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Full time legal assistant/paralegal wanted for our busy office. Experience in estate and trust administration, with proficiency in Microsoft Office and Lackner helpful. Knowledge of real estate, estate planning preferred but not required. Salary commensurate with experience. Excellent benefits.
Full time legal assistant/paralegal wanted for our busy office. Experience in real estate and title insurance, business, tax and estate planning preferred, with proficiency in Microsoft Office and Softpro real estate software helpful. The position involves assisting two attorneys directly, as well as providing assistance with real estate transactions to all (6) attorneys.
Salary negotiable and commensurate with experience.
While our physical operations are currently limited by Governor Wolf’s Order, we remain dedicated to our clients and we will operate by appointment only and remotely through the duration of the COVID-19 pandemic, in accordance with the “Green Phase” re-opening guidelines. We are here to assist individuals and businesses through these uncertain times and are available to answer any questions you may have. Do not hesitate to contact us seeking guidance related to the recently enacted Family First Coronavirus Response Act and any other legal questions you may have as a result of the pandemic.
The MFDD family wishes safety and health to our clients and all members of our community through these trying times.
Once again, MFDD entered a relay team in the 2019 St. Luke’s Via Marathon held on Sunday, September 8th. Beautiful weather and temperatures helped carry our team through the 26.2 mile course stretching from Allentown to Easton in support of people and families with disabilities here in the Lehigh Valley. Since 1952, Via has provided vital services for individuals and their families, ranging from early childhood developmental support to services for people in retirement. MFDD was once again a water station sponsor and proud to be involved with this wonderful event.
Barry Mosebach and Bill Dayton attended the recent 2019 “Agriculture to Industry” Gala in support of the National Museum of Industrial History. Celebrating our industrial past, present and future, NMIH remains dedicated to educating and inspiring those in our community whose industrial achievements continue to transform the nation, and we were proud to support the event and its mission.
The Pennsylvania Supreme Court has ruled that an employer has a legal duty to use reasonable care to safeguard its employees’ sensitive personal information that it requires an employee to provide and that the employer stores on an internet-accessible computer system, and that an employee can recover economic damages resulting from the misuse of such information if the employer failed to utilize adequate measures to prevent its theft. The decision is new law in Pennsylvania, and exposes an employer to significant potential liability in the event its computer system is hacked.
The case, Ditman v. UPMC D/B/A The University of Pittsburg Medical Center (November 21, 2018), involved a claim by employees that their personal and financial information, including names, birth dates, social security numbers, addresses, tax forms, and bank account information were accessed through a data breach of the employer’s internet-accessible computer system, and that the stolen data was used to file fraudulent tax returns on behalf of the employees.
This decision raises questions which will need to be answered by future decisions. What constitutes reasonable measures to protect an employee’s sensitive personal and financial information from the foreseeable risk of a data breach? Is expensive and often cumbersome encryption technology required? What are “adequate” firewalls and authentication protocols?
Perhaps more critical, are there any limitations on the damages an employee can recover? The criminal use of stolen data can cause significant losses to victims. Although a concurring and dissenting opinion suggests the possibility of limiting damages to “mitigation damages”, the majority opinion did not address the issue (the case was before the Supreme Court at a pre-trial stage, so the issue of specific damages was not before the Court).
Employers should consult with their computer services provider about the cost and efficiency of enhanced security measures for their employee information. Insurance providers should also be consulted about available coverages.
Is my Will still legal if I move to another state?
Each year, millions of people move to a new state. If you are among them, you may be wondering whether the estate planning documents (typically a Will, Power of Attorney, and Living Will) you signed in your former state will be valid in your new state. The good news (as qualified below) is most states do have “savings statutes” that recognize the validity of a will if it was validly executed under the law at the place of execution. That means if your will complied with the laws of the former state, the new state should accept it.
Nevertheless, even though it is likely your new state will recognize your will, it is still in your best interest to discuss your particular circumstances with an estate planning attorney. Items to consider include:
Executor – Does the person named as executor in your will live out-of-state? If so, there may be additional complications and expenses, and in that case, you may be better suited naming an executor who resides in the new state. Moreover, some states impose restrictions on who may serve as executor, such as a requirement the executor live in the state or otherwise be a blood relative of the decedent.
Probate – The probate process varies from state to state. For example, in Pennsylvania, the court generally takes a “hands-off” approach and allows an executor to administer estate assets without much oversight. Courts in other states (e.g., California) can be much more involved, which results in a lengthier, more expensive process. All this is to say, if you moved to a state with a more rigorous probate process, you should consider implementing probate-avoidance strategies into your estate plan (e.g., a revocable trust).
Marital Property – Moving from a “community property state” to a “common law state” or vice versa can also create problems with your estate plan. In general, in community property states spouses own all property acquired during marriage jointly (subject to certain exceptions). In common law states, each spouse normally owns only what is in his or her name; but, these states typically have rules to protect a surviving spouse from being disinherited (e.g., Pennsylvania grants a surviving spouse the right to an “elective share”). Because of the different ways spousal property is treated from state to state, it is recommended that you consult with an estate planning lawyer.
Death Taxes – Did you move from a state with no death tax regime to one that imposes and Estate Tax, Inheritance Tax, or both? Or, do your documents include various formula clauses and trust provisions that would be unnecessary without any death tax concerns? In any event, because of the many differences among the state’s death tax regimes, it is a good idea to review the tax-planning aspects of your plan with a qualified estate planning attorney.
Advanced Directives and Healthcare Power of Attorneys – While some states have laws explicitly accepting Advanced Directives and Healthcare Power of Attorneys that were signed in other states, others do not have any laws on the subject. In states that do not have laws accepting out-of-state advanced directives or healthcare power of attorneys, healthcare providers may be hesitant, or even outright refuse, to accept such out-of-state documents. It is always a good idea to consult with an estate planning attorney in your new state regarding the validity of these documents.
Overall, although it is fair to say that a will validly signed in one state will be recognized by another, that does not mean you should forgo consulting with an estate planning attorney. Differences in state law may create unintended consequences for your plan, and without revising your plan accordingly, your assets may not pass in the manner you intended. Therefore, it is important to consult with an estate planning attorney in your new area. We at MFDD would be happy to discuss these issues with you. Please feel free to give us a call at 610-882-9800.
 Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin; Alaska is an opt-in state.
A Way to Save Tax on Capital Gains
Qualified Opportunity Zones under the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act introduced Qualified Opportunity Zones, which are intended to encourage private investment into certain low-income communities throughout the country. In general, the Qualified Opportunity Zone legislation allows investors with capital gains tax liabilities to receive favorable tax treatment if those capital gains are invested in Qualified Opportunity Zone Funds (“QO Funds”). The program’s goal is to tap into the significant amount of unrealized capital gains held by investors throughout the country for use in improving low-income urban and rural communities nationwide.
What are the Benefits?
The following tax benefits are available to investors who reinvest gain from the sale of property into QO Funds:
Temporary Deferral – If a taxpayer timely reinvests gain in a QO Fund, that gain may be deferred until the earlier of the taxpayer’s disposition of the QO Fund investment or December 31, 2026.
Capital Gain Reduction – If the taxpayer holds the QO Fund investment for at least 5 years, 10% of the original deferred gain is excluded from tax; if the taxpayer holds the investment for at least 7 years, an additional 5% of the original deferred gain is excluded from tax (for a total of 15%).
Exclusion of Investment Appreciation – If the taxpayer holds the QO Fund investment for at least 10 years, all post-acquisition appreciation in the investment will be tax-free.
What are Qualified Opportunity Zones?
Qualified Opportunity Zones are population census tracts (i.e., areas roughly the size of a neighborhood) designated by the Governor of each state that are located in low-income communities or are contiguous with low-income communities. Governors may designate up to 25% of the low-income census tracts and up to 5% of contiguous tracts in their states as QO Zones. For purposes of the QO Zone legislation, a “low-income community” has the same meaning as under the New Markets Tax Credit provisions of Section 45D of the Internal Revenue Code.
Each Governor will submit proposed QO Zones to the Treasury Department, which will review the nominations and certify those that meet the statutory requirements. A map of “low-income communities” and designated QO Zones can be found on the Community Development Financial Institutions Fund (“CDFI Fund”) website at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
What are Qualified Opportunity Funds?
Qualified Opportunity Funds (“QO Funds”) are the investment vehicles taxpayers will use to invest their deferred capital gains in the QO Zones. QO Funds can be organized as partnerships or corporations for the purpose of investing in QO Zone Property (other than another QO Fund), and must hold at least 90% of assets in QO Zone Property.
QO Funds will need to be certified by the Treasury Department, and guidance regarding that process will be forthcoming. It is expected that the certification process for QO Funds will be similar to the process by the CDFI Fund for community development entities for New Market Tax Credit purposes.
What is QO Zone Property?
QO Zone Property includes qualified opportunity zone stock, qualified opportunity zone partnership interests, or qualified opportunity zone business property. Overall, there are few limitations on the types of property a QO Fund can invest in so long as the investment is made in a QO Zone. Accordingly, QO Funds can invest in real estate projects (whether residential, commercial, or mixed-use) or businesses that have substantially all property in a QO Zone.
A QO Fund, however, cannot invest in any of the following “sin” businesses: any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Mechanics of a QO Fund Investment
Although implementation of the QO Zone incentive program may prove more complicated, the general concepts of the program are relatively straightforward:
- A QO Fund is formed and certified by the Treasury Department.
- An investor with recently realized capital gain elects to invest that capital gain into the QO Fund, receiving stock or a partnership interest in return. By doing so, the investor may defer including the capital gains in income.
- The QO Fund uses the investment to acquire QO Zone Property. This investment represents the QO Fund’s interest in the underlying business in the low-income community.
- The investor holds the QO Fund interest for as long as desired or as provided in an investment agreement with the QO Fund.
- If the investor sells or exchanges the QO Fund interest before December 31, 2026, he will recognize the deferred capital gain. If, however, his holding period is at least 5 years, he receives a 10% basis step-up in the deferred gain. If his holding period is at least 7 years, he receives an additional 5% basis step-up.
- Regardless of whether the investor sells his interest, there is a recognition event on December 31, 2026, at which time the investor must recognize the deferred capital gain (subject to the basis adjustments noted in Step 5).
- If the investor continues to hold the QO Fund interest for at least 10 years, he is entitled to a fair market value basis step-up so that any appreciation in the value of the interest is completely excluded from income upon disposition of the interest.
Examples of Potential Tax Benefits from a QO Fund Investment
The following examples demonstrate the potential advantages of investing in a QO Fund:
- QO Fund Investment is Held for 5 Years and Sold in 2023
|QO Fund Investment Held for at Least 5 Years||Ordinary Investment||Difference|
|Deferred Capital Gain||$500||Capital Gain||$500|
|Basis Step-Up||$50||Basis Step-Up||$0|
|Taxable Gain (taxed in 2023)||$450||Taxable Gain (taxed in 2018)||$500|
|Tax (at 23.8%)||$107.10||Tax (at 23.8%)||$119||$11.90|
By investing capital gains in a QO Fund and holding that investment for at least 5 years, a taxpayer could defer recognizing the capital gain until 2023 and would save about $12 in tax.
- QO Fund Investment is Held for 7 Years and Sold in 2025
|QO Fund Investment Held for at Least 7 Years||Ordinary Investment||Difference|
|Deferred Capital Gain||$500||Capital Gain||$500|
|Basis Step-Up||$75||Basis Step-Up||$0|
|Taxable Gain (taxed in 2025)||$425||Taxable Gain (taxed in 2018)||$500|
|Tax (at 23.8%)||$101.15||Tax (at 23.8%)||$119||$17.85|
By investing capital gains in a QO Fund and holding that investment for at least 7 years, a taxpayer could defer recognizing the capital gain until 2025 and would save about $18 in tax.
- QO Fund Investment is Held for 10 Years and Sold in 2028
|QO Fund Investment Held for at Least 10 Years||Ordinary Investment||Difference|
|Deferred Capital Gain||$500||Capital Gain||$500|
|Basis Step-Up||$75||Basis Step-Up||$0|
|Taxable Gain (taxed in 2026)||$425||Taxable Gain (taxed in 2018)||$500|
|Tax (at 23.8%)||$101.15||Tax (at 23.8%)||$119||$17.85|
|QO Fund Investment Appreciation||$1,000||Investment Appreciation||$1,000|
|Basis Step-Up||$1,000||Basis Step-Up||$0|
|Taxable Gain on Sale of QO Fund Investment||$0||Taxable Gain on Sale||$1,000|
|Tax (at 23.8%)||$0||Tax (at 23.8%)||$238||$238|
By investing capital gains in a QO Fund and holding that investment for 10 years, and assuming the investment in the QO Fund doubles over that period, a taxpayer could defer recognizing the capital gain invested in the QO Fund until 2026 and would save about $256 in tax overall.
The Qualified Opportunity Zone legislation has the potential to benefit both investors who wish to defer capital gains tax and low-income communities in need of capital for business and community development. For further information, please contact the tax attorneys at Mosebach, Funt, Dayton & Duckworth, P.C.
Attorney William H. Dayton, Jr. was selected as the Lehigh Valley Community Foundation (LVCF) Survey winner. LVCF requested that professional advisors complete a survey on the different aspects of charitable giving. As survey winner, Attorney Dayton was able to direct a $250.00 gift from LVCF to the charity of his choice. He selected The Fund to Benefit Children & Youth. Attorney Dayton practices in the area of business, real estate, estate planning, probate, and elder law.
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