Subchapter Z of the Internal Revenue Code, created by the Tax Cuts and Job Act of 2017, provides taxpayers with incentives for investing in “Qualified Opportunity Zones.” These are specifically designated areas in need of economic development that are nominated by states and certified by the Secretary of the U.S. Treasury. Taxpayers who invest certain kinds of capital gains into these Qualified Opportunity Zones (QOZs) may be able to defer, and in some cases even permanently exclude, these gains from their taxable income. We described these benefits very generally in an earlier article. The article you are reading goes into greater detail regarding the qualifications and benefits, and incorporates some recent guidance provided by the IRS.
HOW DO I QUALIFY FOR THE BENEFITS?
Three benefits are available, and to qualify for ANY of them, a taxpayer must:
- Have invested money into an investment that was, at the time of the investment, designated as a Qualified Opportunity Zone (QOZ), and
- Have generated the means for that funding using proceeds from a previous, completely unrelated sale that resulted in a capital gain.
- Observation: An amount greater than the original transactions gain may be invested in an OZ, but the gain and the non-gain portions of the investment must be tracked separately, and only the portion related to the gain qualifies for the favorable treatment described below.
WHAT ARE THE BENEFITS?
A taxpayer can utilize any or all of the following three benefits, assuming the qualifications are met for each one.
- A temporary deferral of capital gain on the sale of a property IF the gain is reinvested in a Qualified Opportunity Fund within 180 days of sale. Such gains may be deferred until the earlier of (a) the taxpayer’s subsequent sale of the fund or (b) 12/31/2026.
- Reduction of recognized gain (accomplished through a basis step-up), resulting in a permanent exclusion of gain of up to 15%:
- For OZ property held for 5 years, 10% of deferred gain is allowed as a basis step-up.
- For OZ property held for 7 years, another 5% of deferred gain is added to basis.
- If the OZ investment is held at least 10 years, the taxpayer may elect step-up of investment to FMV, potentially resulting in NO taxable gain, and a permanent exclusion.
WHERE ARE THE ZONES?
INVESTMENT OF THE GAIN
In order to utilize the potential tax savings of Qualified Opportunity Zones, a taxpayer will need to first generate a qualifying capital gain. The property that generates this gain (and sets the benefits in motion) is completely unrelated to the “qualified” property. The initial property can involve real estate, stocks or bonds, or other types of property. To qualify it simply must generate a capital gain, from the sale or exchange to an unrelated person, with the gain then being invested into a Qualified Opportunity Fund (QOF) within 180 days of the underlying sale (QOFs will be defined later). Let’s review an example to clarify the qualifications described above:
- Example: Suppose a taxpayer sells a capital asset for $100,000 on January 1, 2018, at a time when her basis in that asset is $60,000. This results in a gain of $40,000. The sale transaction triggers a 180 day countdown where the taxpayer can elect to reinvest the $40,000 gain into a QOF. The taxpayer does not need to reinvest the entire $100,000, though she may choose to do so. However, only the $40,000 will be eligible for gain deferment, and, if the investment in the QOF appreciates and triggers future taxable gains, only the portion related to the original, reinvested gain (the $40,000, in this example) will be eligible for favorable treatment. The remaining proceeds of $60,000, if it is also invested into a QOF, would just represent a “regular” capital asset to the taxpayer.
There are some additional qualifications to the 180 day window. If the underlying sale occurs at the entity level, the 180 day countdown technically starts on December 31 in the year of sale, rather than the literal sale date. For sales that occur at the individual level, taxpayers have the election of starting their 180 day countdown on December 31 in the year of sale, or on the actual sale-date.
QUALIFIED OPPORTUNITY FUNDS:
For any of the Subchapter Z benefits to be achieved, the gain described above must be reinvested in a Qualified Opportunity Fund (QOF).
A QOF is a designated business entity that can be structured as either a corporation or as a partnership (for the purposes of this article, we will continue to refer to QOFs as “Funds”) that exists for the primary purpose of investing in designated opportunity areas, as determined by the IRS and the Secretary of the US Treasury. In order to maintain QOF status, 90% of the assets held by the Fund on the last day of the taxable year must be Qualified Opportunity Zone Property, and the fund must have acquired the property from an unrelated party after December 31, 2017. We will cover Qualified Opportunity Zone Property in greater detail in the next section.
The QOF must pass this 90% test every six months, and the assessed value for the test is based on the Fund’s audited financial statements, or, if such statements are unavailable, the cost basis of its assets. Taxpayers will use Form 8996, Qualified Opportunity Fund, to self-certify compliance with the 90% test.
QOFs may choose the first month that they elect to be a QOF. If the Fund fails to elect a specific date, then the default treatment is for QOF status to begin in the first month of the Fund’s initial year.
To summarize, a taxpayer who has recognized a capital gain will have 180 days to reinvest that gain into a Qualified Opportunity Fund. A timely and proper investment into a QOF will eventually allow the taxpayer to defer or ultimately exclude a portion of that gain from their taxable income, as long as the designated QOF maintains its qualified status. A QOF does this by ensuring that 90% or more of its assets consist of Qualified Opportunity Zone Property. The next step in this process is to understand what “Qualified Opportunity Zone Property” is.
QUALIFIED OPPORTUNITY ZONE PROPERTY:
Qualified Opportunity Zone Property relates to tangible property located in areas in need of economic development, as designated by the IRS and respective state officials. In order for the gain that a taxpayer reinvests into a QOF to qualify for deferral and exemption, that QOF will need to hold 90% of its assets in Qualified Opportunity Zone Property. There are three types of qualifying property:
- Qualified Opportunity Zone Stock (QOZ stock)
- Qualified Opportunity Zone Partnership Interest (QPI)
- Qualified Opportunity Zone Business Property (QOZ Property)
While each property type listed above has its own requirements that need to be met to qualify as eligible property, there is one factor that all three have in common: the property must be acquired after December 31, 2017.
In addition, Qualified Opportunity Zone Property has to be purchased from an unrelated party (in this case, defined as an entity with less than 20% ownership to the fund or underlying taxpayer), and the original use of the property in the zone commences with the QOF’s investment, or the Fund substantially improves the property from its original state.
To be considered “substantial improvement”, the QOF’s investment and improvement of the property needs to occur during the 30 month period after the date of acquisition of the property, and the cost of the additions to the property, while it is held by the QOF, must exceed the basis of the property at the beginning of the 30 month period (the basis in the land, however, is excluded). To simplify: the QOF must put more money into improving the property than it cost to buy it.
It is also important for the reader to know that cash holdings do not count towards the 90% test, or as Qualified Opportunity Zone Property – that is, the cash has to actually be put to work. A working capital safe harbor has been provided by the IRS for property that is held by the QOF for a period of up to 31 months, if there is an official plan and schedule that identifies the financial property as held for the acquisition, construction, or substantial improvement of tangible property within the qualified zone. The QOF is required to comply with that schedule, to prove that the QOF is not merely sitting on cash but is actually working to stimulate economic development.
We have now established the initial process for how to defer or exclude capital gains from taxable income under Subchapter Z: the taxpayer must realize a capital gain, that gain must be invested in a Qualified Opportunity Fund, and that Fund must consistently hold 90% or more of its assets in Qualified Investment Zone Property. It is now time to get to the real incentive behind Subchapter Z for taxpayers: how the gain deferment and exclusion actually work, and the benefits available to the taxpayer.
DEFERRED AND EXCLUDED GAINS:
If the original capital gain (not gross proceeds) is reinvested into an eligible QOF within the 180 day window, the original gain will be deferred from taxable income until the earlier of:
- The date the investment in the QOF is sold, or
- December 31, 2026.
For taxpayers who have sold and reinvested their gains in 2018, this provides a maximum deferral period of nine years.
When taxpayers reinvest their gains into a QOF, their initial basis in the fund will be zero. However, as the taxpayers hold their investments within the QOF, their basis will increase. This incremental step-up process effectively excludes part of the gain from taxable income.
If the taxpayer holds a QOF investment for 5 years, the basis will be increased by 10% of the amount of the original gain. If the taxpayer holds the investment for 7 years, the taxpayer’s basis will be increased by an additional 5% of the amount of the original gain – this creates a total basis step up of 15%. In order to receive this entire benefit, a gain would need to be invested 7 years prior to December 31, 2026 deadline – that is, by no later than December 31, 2019. On December 31, 2026, the taxpayer will recognize the deferred gain and take one final step-up in basis to the total gain from the original transaction.
While these incremental basis step-ups are already beneficial to the taxpayer, Subchapter Z has one final component that represents massive savings opportunities: if taxpayers hold their underlying investment in the QOF for greater than 10 years, and then sell their QOF investments before December 31, 2047, then when the investment is sold, the taxpayers can elect to treat their basis in the QOF as equal to fair market value at the time of disposal. In other words, the taxpayer’s basis will equal its proceeds at time of sale, and no taxable gain will be recognized.
- Consider the facts and circumstances from the previous example: the taxpayer has just realized a $40,000 capital gain on January 1, 2018, and has 180 days to reinvest the $40,000 into a Qualified Opportunity Zone stock. Supposing the taxpayer properly reinvests the gain (instead of selling the investment), by year five (1/1/23) the basis in the QOF is increased from $0 to $4,000 (10%). By year seven (1/1/25), the taxpayer receives an additional basis step-up of $2,000 (5%), bringing their total basis to $6,000. In year nine, the taxpayer would finally recognize the tax on the deferred gain of the original transaction (recall the deadline of 12/31/2026). Because of the basis step-up, the recognized gain in 2026 is $34,000, as opposed to the original $40,000. Assuming top long-term capital gains rates do not change, this could be a tax savings of up to $1,200 (20% [40,000 - 34,000]). At this point the taxpayer will take an additional step-up in basis to the amount of the original gain – in this example, the taxpayer’s basis will be increased to $40,000.
Now, let’s take it one step further: In Year 11, the taxpayer sells the QOF stock for $200,000, resulting in a gain of $160,000 (proceeds of $200,000 less the previously stepped-up basis of $40,000). The taxpayer has already paid taxes on the $34,000 deferred gain, and because the asset was held longer than 10 years, the basis can be stepped up to the fair market value at the time of disposition – in this case, $200,000. This means that the taxpayer does not recognize any taxable gain on the final disposition; 100% of the gain qualifies for exclusion from taxable income.
Per our example, this means that a taxpayer who ultimately received $300,000 on an original investment of $60,000 only paid taxes on a gain of $34,000, as opposed to the total realized gain of $240,000. At the highest long-term capital gains rate, that is a savings of $41,200 (20% [$240,000 - $34,000]).
The potential tax implications of this deferral process are huge. Not only does it give taxpayers the opportunity to put off recognizing taxable capital gains until a time that is convenient for their planning goals, but for taxpayers who have a longer time horizon, it also presents the opportunity to entirely avoid taxes that they otherwise would have had to pay.
Readers will be unsurprised to know that there are additional caveats for this extremely advantageous tax treatment. As stated, in order to realize the full 100% exclusion, taxpayers will need to sell their investment in the QOF by December 31, 2047. Sales made after this date will no longer qualify for the 100% exclusion.
Taxpayers should also keep in mind the hard-set deadline of December 31, 2026, to recognize the deferred capital gain on the original transaction. Because the taxpayer needs to hold the QOF investment for a total of 7 years to achieve the full 15% deferment on the original gain, any investments made after December 31, 2019 will not qualify for the second 5% basis step-up. Likewise, any gain realized after December 31, 2021 will be ineligible for the 10% basis step-up. If gains are reinvested after these dates, then it will be impossible to hold them for the required 7 and 5 year periods, respectively, before the deadline of December 31, 2026. Gains that are reinvested after 12/31/2021 can be deferred, but they must be recognized in full by 12/31/2026. Gains can still be reinvested after 12/31/2026, but the original gain will need to be recognized at the time of sale. However, the sale of the QOF can still qualify for the 100% exclusion if it is held for more than 10 years and sold by 12/31/2047.
Recall that only the reinvested original gain is eligible for this preferential treatment. In our example, that would be the $40,000 gain on the first $100,000 of proceeds. While the taxpayer could elect to reinvest the entire $100,000 in proceeds, the IRS would view this as two separate investments – one for $40,000, eligible for gain deferral and exemption, and one for $60,000, which would be treated as any other capital asset (and not eligible for any of the benefits described above).
Qualified Opportunity Funds not only promote growth in communities in need of economic development, but they also open up the potential for taxpayers to receive very impressive tax benefits. However, readers should be aware that the proper utilization of these new tax-saving mechanisms requires very careful planning to ensure that all requirements are met. Taxpayers should also be aware that investing in a Qualified Opportunity Fund will require more effort than a typical investment. An investment in a QOF is intended to promote economic growth and development, and it will require more active interest and participation from the taxpayer in order to ensure that substantial improvements are actually made as planned. For taxpayers willing to take on the challenge, this piece of the Tax Cuts and Jobs Act could prove to be a huge win.
Please contact Kristin Redstone at 1.800.244.7444 if you have questions about how you or your business may be affected by these tax law changes.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.