The IRS has issued proposed regulations and a related revenue ruling regarding the designation of certain low-income community population census tracts as Qualified Opportunity Zones (“QO Zones”), eligible for favorable tax treatment as created by the Tax Cuts and Jobs Act (“TCJA”). Since passage of the TCJA in 2017, many taxpayers have eagerly awaited guidance as to how to defer their capital gains into QO Zone property. The gain deferral incentive is aimed at encouraging economic growth and investment in businesses within the QO Zones.
The TCJA introduces two elections:
- The ability to defer gain from the sale of property that is reinvested in an investment in a Qualified Opportunity Fund (“QO Fund”) (temporary gain deferral election) and;
- The ability to permanently exclude gain from the sale or exchange of the investment in the QO Fund (permanent gain exclusion election).
These elections can provide substantial tax benefits for taxpayers who can satisfy the detailed and quite complex set of rules.
Temporary gain deferral election. If a taxpayer invests gains from the sale or exchange of property with an unrelated person in a QO Fund within the 180-day period beginning on the date of the sale or exchange giving rise to the gain, the taxpayer can elect to defer the gain from the sale or exchange. The proposed regulations further clarify that the 180-day period begins on the date which the gain would be recognized for Federal income tax purposes, without regard to the deferral election. Consistent with this rule, a partnership that has capital gain and elects not to defer the gain, passes that capital gain to the partners whose 180-day period begins on the last day of the partnership’s tax year. However, the partner may choose to begin its own 180-day period on the same date as the start of the partnership’s 180-day period, if that information is available.
Unlike other tax deferral tools such as Section 1031 like-kind exchanges, that require the total proceeds to be reinvested, only the gain (short-term, long-term, and Section 1231) deferred has to be reinvested to use this provision. The tax attributes (such as short-term or long-term) of the gain deferred are preserved and are taken into account when the gain is recognized at the end of the deferral period.
Recognition of deferred gain. The taxpayer defers the gain until the later of the date on which the investment is sold or exchanged, or Dec. 31, 2026. If the investment is held until Dec. 31, 2026, the gain subject to tax is the lesser of (1) the fair market value of the property at that time, or (2) the original deferred gain.
Basis in the investment. Because the taxpayer only reinvests the deferred gain in the QO Fund, a taxpayer’s basis in the investment is zero unless any of the following increases apply: (a) 10% of the deferred gain if the investment is held for five years, (b) an additional 5% of the deferred gain if the investment is held for seven years; and (c) any deferred gain recognized at the end of the deferral period.
Permanent gain exclusion election. At the taxpayer’s election, a taxpayer can exclude any post-acquisition capital gains on an investment in a QO Fund if the investment in the QO Fund has been held for ten years. The election can be made as late as December 31, 2047, which gives taxpayers ample time to consider all business and economic factors before disposing of their QO Fund investment. The proposed regulations reiterate that only an investment where a proper temporary gain deferral election (defined above) was made can be stepped up. Invested funds not subject to the deferral election are treated as a separate investment in the QO Fund and are not eligible for the permanent gain exclusion.
When elections can’t be made. A taxpayer can’t make either election if there’s already an election in effect with respect to the same sale or exchange. This prevents a taxpayer from making multiple elections on the same deferred gain and seeking to multiply various step-ups in basis. Also, a taxpayer can’t make a temporary deferral election with respect to any sale or exchange that occurs after Dec. 31, 2026.
Designation of a QO Zone. Under the TCJA, a state’s chief executive officer (CEO) (generally, a governor or the mayor of the District of Columbia) can designate certain census tracts that are low-income communities as QO Zones. In NC, 252 QO Zones have been identified with at least one in every county from the mountains to the coast. Additional information and an interactive map on NC’s Opportunity Zones can be found here: https://public.nccommerce.com/oz/. Information on all QO Zones can be found here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
QO Funds. A QO Fund is an investment vehicle organized as a corporation or a partnership for the purpose of investing in a QO Zone. The investment by the taxpayer in the QO Fund must be an equity interest and not a debt instrument. In addition, the QO Fund must be created or organized in one of the 50 States, the District of Columbia, or a U.S. possession. The regulations provide for additional requirements if the Fund is organized in a U.S. possession.
The QO Fund can’t invest in another QO Fund and has to hold at least 90% of its assets in QO Zone property. QO Zone property includes the following: QO Zone stock, QO Zone partnership interest, and QO Zone business property.
Penalties apply if the QO Fund does not hold at least 90% of its assets in QO Zone property.
Conclusion. Qualified opportunity zones present a tremendous opportunity for taxpayers to defer capital gains and to receive a permanent gain exclusion on their investment in a qualified opportunity fund. To summarize, a taxpayer who realizes a capital gain can elect to defer that gain by investing the gain in a qualified opportunity fund. The taxpayer will recognize and pay tax on the deferred gain on the earlier of Dec. 31, 2026 or when the investment in the QO Fund is sold. The taxpayer can receive a 10% increase in the basis of the investment if the investment has been held for at least five years and an additional 5% increase after seven years for a total of 15% of the deferred gain. After the investment has been held for at least ten years, the post-acquisition capital gains can be permanently deferred. Although tax will eventually be paid on the original gain deferral, the amount of appreciation that occurs in the investment can be tax-free.
An example timeline of events:
In addition to the items highlighted above, the proposed regulations set forth rules for capital gains arising from Section 1256 contracts and offsetting-position transactions, including straddles that have not been covered in this article.
See the proposed regulations (Reg-115420-18) for comprehensive examples.
If an investment in a QO Fund sounds like an attractive opportunity that you would like to hear more about, please contact DMJ.