Defer Income Tax on Capital Gains by Investing in Opportunity Zones
By: Christopher Nuss
Overview of Investing in Opportunity Zones.
To spur economic development in certain distressed communities across America designated as Qualified Opportunity Zones (“QOZ”) through private investment, Congress in the recent Tax Cuts and Jobs Act created a new investment vehicle that provides preferential income tax treatment for reinvesting proceeds from capital gains into a Qualified Opportunity Fund (“QOF”). Provided the requirements discussed later are met, the tax incentives generally include:
- At a minimum, taxation of the capital gains is temporarily deferred until the earlier of when the investment in the QOF is later sold or December 31, 2026.
- Additionally, depending on how long the QOF investment is held, a portion of the deferred capital gain and all appreciation in the QOF investment could be permanently excluded from taxation.
Here in Iowa, three QOZs were designated in Polk County, one in Dallas County, and many more throughout the state. Currently, there are more than 8,700 QOZs across the country.
Note that only recently has the Internal Revenue Service (“IRS”) issued guidance, much of it via proposed regulations, to clarify these statutory rules, with final guidance not expected until next year.
Capital Gains Eligible for Reinvestment and the Timeliness of Rolling Over those Capital Gain Proceeds.
Capital gains eligible for this special tax treatment are broadly defined to include capital gains realized from “the sale to, or exchange with, an unrelated person of any property held by the taxpayer” that would have been required to be recognized by December 31, 2026 (if not for the deferral explained herein). Some types of capital gains have further limitations on eligibility, including, but not limited to, capital gains already subject to an election and derived from Section 1256 contracts or certain offsetting-position transactions, such as straddles. Note that investing a combination of deferral-eligible and ineligible capital gains in a QOF is allowed, but will result in separate investments with different tax treatments.
Taxpayers must reinvest the proceeds from their capital gains into a QOF generally within 180 days from the date of the sale that generated the capital gain. (The IRS proposed regulations clarify how to apply the 180-day period to different taxpayers and varying types of capital gains.)
Eligible taxpayers include individuals, C corporations (including regulated investment companies and real estate investment trusts), and most pass-through entities. Furthermore, if an eligible pass-through entity does not elect to defer gain by choosing to invest in a QOF, the owner or beneficiary of such entity can be eligible to do so.
To defer capital gains by investing in a QOF, taxpayers must make an election in the year in which the tax would have been due (anticipated to be made on Form 8949).
What is a Qualified Opportunity Fund (QOF)?
A QOF can be formed as a partnership or corporation for federal income tax purposes (thus including limited liability companies), so long as it is organized for the purpose investing at least 90% of its assets in “QOZ property.” This property includes equity in a corporation or partnership that is conducting a “QOZ business.” Basically, a QOZ business is an active trade or business being conducted in a QOZ whereby substantially all of the property owned or used by the business was acquired after 2017 for original use in such business. “Sin” businesses do not qualify, including, for example, a golf course, country club, massage parlor, suntan facility, gambling facility, or any store whereby the principal business is selling alcohol for consumption off the premises.
QOF investments do not include debt instruments or investments in other QOFs.
The QOF will self-certify as a QOF thereby not requiring “pre-approval” by the IRS. Then,
compliance with the QOF’s 90% asset test is verified semi-annually and reported annually (anticipated to be on Form 8996). Naturally, there are penalties for failing to meet the 90% asset test.
The Income Tax Incentives in more Detail.
As mentioned above, the applicable tax incentives depend on how long the taxpayer holds the investment in the QOF.
- At minimum, the tax due on the initial capital gain is temporarily deferred until the earlier of when the QOF investment is later sold or December 31, 2026.
- Then, holding the QOF investment at least five years results in completely excluding from taxation 10% of the initial capital gain. And if the QOF investment is held longer, for at least seven years, the capital gain exclusion increases an additional 5% (for a total of 15%).
- Finally, if the QOF investment is held at least ten years, in addition to the 15% exclusion from tax on the initial capital gain, the taxpayer can also permanently exclude any and all appreciation on the investment held in the QOF.
Timing is critical in properly reinvesting your capital gains (e.g., within 180 days from the date of sale). And the sooner you reinvest, the potentially greater the tax benefits will be if you remain invested through December 31, 2026.
If you are interested in taking advantage of this new investment vehicle, please contact your BrownWinick attorney or one of our tax attorneys listed below.
Christopher Nuss (P) 515.242.2432 (E) firstname.lastname@example.org
Maggie Simonson (P) 515.242.2439 (E) email@example.com