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 DeferralIf 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:

  1. A QO Fund is formed and certified by the Treasury Department.
  2. 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.
  3. 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.
  4. The investor holds the QO Fund interest for as long as desired or as provided in an investment agreement with the QO Fund.
  5. 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.
  6. 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).
  7. 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:

  1. 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.

  1. 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.

  1. 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
$255.85 Total

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.

Conclusion

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.