President Trump signed the Tax Cuts and Jobs Act (“TCJA”) on December 22, 2017. This $1.4 trillion tax cut was expected to lower taxes for middle-class Americans and bring back jobs to the United States. One of the new provisions in this act was the creation of “Qualified Opportunity Zones” under Internal Revenue Code 1400Z-1 and 1400Z-2. These Qualified Opportunity Zone provisions could provide businesses, projects, and commercial property in eligible low-income census tracts, attractive financing for economic development. They could also provide opportunities for investors, individuals and corporations, to defer tax on current capital gains, significantly increase tax basis in their current investments, and abate all future tax on capital gains from these investments.
A “Qualified Opportunity Zone” is a population census tract that is a low-income community that is designated as a qualified opportunity zone. The governor of each state and the US Treasury Department certify the qualified opportunity zones within a state. In Arizona, portions of: Phoenix, Scottsdale, Glendale, Tempe and Mesa have been designated as Opportunity Zones.
This new tax provision provides an effective deferral mechanism for short and long-term capital gains from current investments in nearly all asset classes including stocks and other securities. Unlike Section 1031 “like-kind” deferral, qualified opportunity zones will provide: (i) the ability to invest only the gain rather than the entire current investment, (ii) a broader range of investments eligible for the deferral, (iii) a potential basis step-up of 15 percent of the initial deferred amount of investment, and (iv) an opportunity to abate all taxation on capital gains post-investment.
The new provision allows taxpayers to defer the short term or long-term capital gains tax due upon a sale or disposition of property if the capital gain portion of the sale or disposition is reinvested within 180 days in a “qualified opportunity fund.” A “Qualified Opportunity Zone Fund” is a corporation or partnership that invests at least 90 percent of its assets in qualified opportunity zone property.
If the investment is maintained in the “qualified opportunity fund” for five years, the taxpayer will receive a step-up in tax basis equal to 10 percent of the original gain. If the investment is maintained in the “qualified opportunity fund” for seven years, the taxpayer will receive an additional five percent step-up in tax basis. A recognition event will occur on Dec. 31, 2026, in the amount of the lesser of (i) the remaining deferred gain or (ii) the fair market value of the investment in the “qualified opportunity fund.” Investments maintained for 10 years and until at least Dec. 31, 2026, will allow for an exclusion of all capital gains, from post-acquisition gain on the investment in a “qualified opportunity fund”, to be excluded from gross income. For an investment maintained longer than 10 years and upon a sale or disposition of the investment, the new provision also allows the taxpayer to elect the basis in the investment to be equal to the fair market value of the investment.
John Taxpayer bought stock in XYZ Corporation in 2010 for $20,000, and today it is worth $40,000. John thinks XYZ Corporation stock has topped out and he wants to sell; selling will cause John to realize $20,000 in capital gain. Before Opportunity Funds, there were only two choices: (1) continue to hold the stock and defer the gain/tax, or (2) sell and pay over $4,000 in income tax. Now there is a third choice – the Opportunity Fund. If John sells his XYZ Corporation stock for $40,000, and reinvests the $20,000 gain in an Opportunity Fund, he gets to keep his original investment of $20,000 and pay no taxes*. If John leaves his $20,000 in the Opportunity Fund for 10 years and it increases in value to $40,000, he gets the post-acquisition gain of $20,000 in year 10 entirely tax free.
*The deferral of tax on John’s initial $20,000 gain is good until 2026 and then the gain must be recognized, but with certain advantages explained in detail below.
John receives three benefits from his Opportunity Fund Investment:
1) Capital Gains Tax Deferral until 2026 – Because he rolls his initial gain into an Opportunity Fund, John does not pay tax on the $20,000 gain today. He does pay the tax in 2026, but in the meantime his $20,000 gain has been invested and is earning a return.
2) Basis Step up of 15% – Not only does John keep his $20,000 gain invested and earning a return for 8 years, the gain that John pays tax on in 2026 is reduced by 15%. Rather than paying tax on $20,000 of gain on his XYZ Corporation stock, he will pay tax on only $17,000.
3) 100% Capital Gains Exclusion – If John leaves his $20,000 invested in the Opportunity Fund for 10 years, his gain on the $20,000 is tax free. In our example, if John’s Opportunity Fund investment appreciates at 7% per year, then in year 10 John would receive back his $20,000 initial investment, plus an additional $20,000 in tax-free capital gains.
While Qualified Opportunity Zone Funds appear to offer some significant tax advantages, they are still very new. Although the US treasury and IRS are charged with monitoring the program, their oversight mechanisms aren’t fully set up yet. That means that anyone could create a fund and solicit investors. There’s no guarantee that the projects will fit within the Qualified Opportunity Zone requirements or that the project will be successful. As always, you must perform your due diligence to make certain that you understand how the program works and whether your investment meets the Qualified Opportunity Zone requirements.
One of the new provisions in the JCJA was the creation of “Qualified Opportunity Zones.” under Internal Revenue Code 1400Z-1 and 1400Z-2. These Qualified Opportunity Zone provisions could provide businesses, projects, and commercial property in eligible low-income census tracts attractive financing and what could amount to a substantial long-term subsidy for economic development. They could also provide opportunities for investors, individuals and corporations, to defer tax on current capital gains, significantly increase basis in their current investments, and abate all future tax on capital gains from these investments.
Please let us know if you have questions concerning Qualified Opportunity Zones or any other tax compliance or planning issues. Call us today (480) 980-3977.
Paul J. Beckert MBA, CPA
Note: The information contained in this material represents a general overview of tax and should not be relied upon without an independent, professional analysis of how any of these provisions apply to a specific situation.