Using Opportunity Zones to Defer Tax on Gains
The Tax Cuts & Jobs Act (“TCJA”) ushered in a host of new tax laws. One of these laws provided for opportunity zones. The tax benefits associated with these zones can be significant and are worth considering for anyone who wants to defer the tax that would be due on capital gain from the sale of property.
What is an Opportunity Zone?
The Code defines the term “opportunity zone” as “a population census tract that is a low-income community that is designated as a qualified opportunity zone.” It goes on to say that the states have the ability to nominate these zones and the Treasury Department certifies them.
When the opportunity zone legislation was being debated in Congress, many tax professionals did not pay attention to it, thinking that the zones would be far-and-few-between and located in remote areas where few would want to invest. But it turns out that there are quite a lot of areas that were designated and they are located in many areas that investors would consider investing. There are several of searchable maps that can be found on the Internet that show where these opportunity zones are located.
Tax Benefits for Opportunity Zones
When it comes to income tax planning, most strategies involve excluding income, deferring income, generating a tax credit or deduction, or changing the character of gain or loss to get a different tax rate. Opportunity zones allow for two of these items, namely, income exclusion and income deferral.
The income exclusion relates to the opportunity zone investment itself. If the taxpayer holds an opportunity zone investment for less than five years, there is no income exclusion benefit.
But if he holds the opportunity zone investment for 5 or 7 years, his tax basis in the opportunity zone investment goes from $0 to 10% and 15% of the amount of gain originally invested into the opportunity zone. Thus, a $100 gain invested in the opportunity zone would result in a $10 and then a $15 tax basis in the opportunity zone investment in year 5 and 7, respectfully. This allows the $10 and $15 to not be subject to income tax.
This income exclusion is even better if the investor holds the investment for 10 or more years. Then the investor’s basis is stepped up to the fair market value as of that date. This allows the full appreciation on the opportunity zone to not be subject to income tax.
The income deferral relates to the original property that was sold. This is the sale that triggered the gain which was invested into the opportunity zone within 180 days of the sale. No tax is due on the sale. The gain is deferred to the earlier of December 31, 2026 or when the opportunity zone investment is sold.
This income deferral is better than the deferral achieved in an I.R.C. § 1031 exchange, as the 1031 exchange requires the taxpayer to invest the whole proceeds from the exchange into the replacement property. Section 1031 exchanges are not limited to just reinvesting the gain from the original sale, like opportunity zones are.
The Opportunity Zone Rules
There are a number of rules that must be followed to realize the tax benefits associated with opportunity zones.
First, there has to be a property that is located in an opportunity zone. This property can include tangible property used in business in a qualified opportunity zone, such as real estate or equipment. This has to be for (1) land in an opportunity zone or (2) a building or equipment in an opportunity zone that is first used by the taxpayer or, if previously used, is “substantially improved.”
Second, used property has to be substantially improved. This requires the taxpayer to invest more in the tangible property during any 30-month period than the adjusted basis in the property at the beginning of the period. This requirement does not apply to land. For buildings, the regulations clarify that this is examined at the building, and not the building subcomponent, level.
Third, the property can be held directly or in a qualified opportunity zone fund (“QOF”). The QOF must qualify. This requires the QOF to receive at least 50% of its gross income from the “active conduct of” a business in an opportunity zone. And if the QOF owns intangible assets, a substantial portion of the assets must be used in the QOF business. The QOF must also be a legal entity taxed as a partnership or a corporation. Last, the business cannot include one or more of the following activities: golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, casino or sale of alcohol to be consumed away from the premises.
While the TCJA provides the base rules and the IRS has released proposed regulations, there are a number of questions that have yet to be answered. These questions are difficult to square given the somewhat complex nature of the qualification rules and the language Congress used in the statute.
The IRS is expected to issue additional regulations soon to address many of these uncertainties.
Given the potentially sizeable tax savings, investors looking to defer tax on capital gains should definitely explore opportunity zones as an option.
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