Opportunity Zones May Spur Economic Growth Through Investor Tax Incentives
The Tax Cuts and Jobs Act of 2017 (TCJA) includes a new tax incentive designed to steer long-term capital investments into economically distressed communities. Investments in these areas, called Opportunity Zones, are eligible for the temporary deferral and potential exclusion of capital gains.
Tax benefits of investing in an Opportunity Zone
The TCJA authorizes each state to nominate up to 25 percent of its low-income communities as qualified Opportunity Zones. The final list of designated census tracts was released by the U.S. Department of Treasury on June 14, 2018.
Temporary deferral of gain
Proposed tax regulations for the Opportunity Zone program (IRC Section 1400Z-1 and 1400Z-2) provide that gain from the sale of property to an unrelated person or exchange of any property occurring prior to January 1, 2027, need not be included in the taxpayer’s gross income if the sale amount is invested in a qualified opportunity fund within 180 days from the date of the sale or exchange. There is no limit on the amount of gain eligible for this deferral, although watch the timing rules on the 180-day reinvestment period.
A qualified opportunity fund is generally any investment vehicle organized as a corporation or partnership that holds at least 90 percent of its assets in Qualified Opportunity Zone property. At this time there is no formal approval process for an entity to become a qualified investment fund; instead, an eligible taxpayer self-certifies by attaching a form to federal income tax returns.
The deferred gain must be included in income in the tax year which includes the sale or exchange of the Opportunity Zone investment, or by December 31, 2026, whichever comes first. However, the amount of gain that must be recognized is reduced incrementally the longer the investment is held through an increase to basis. If held for at least five years, the basis of the investment is increased by 10 percent of the gain deferred; if held for at least seven years, the basis is increased to 15 percent of the gain deferred.
Permanent exclusion of gain
For any Opportunity Zone investment held at least 10 years, taxpayers may make an election to step up the basis of their investment to its fair market value on the date it is sold or exchanged. In this way, long-term Opportunity Zone investments can enjoy tax-free appreciation. Note that this basis step-up does not avoid the inclusion of gain described above with respect to the rollover investment.
Example of tax savings with a 10-year holding period
Cindy sells X Corporation stock on June 1, 2018, at a gain of $200,000. Within 180 days, she invests the $200,000 in a qualified opportunity fund. Cindy then sells her Opportunity Zone investment on January 1, 2029, for $415,402.
Cindy may defer the $200,000 of gain from the X Corporation stock until 2026 since it was invested in a qualified opportunity fund within 180 days. In tax year 2026, she is required to recognize the deferred gain; however, because Cindy held her investment for at least seven years, her basis in the investment is increased by 15 percent (i.e., from zero to $30,000), resulting in a taxable gain of $170,000 rather than the full $200,000 that was originally invested. Assuming a tax rate of 23.8 percent (capital gains rate of 20 percent plus the 3.8 percent net investment income tax), Cindy owes tax in 2026 of $40,460 rather than the $47,600 that would have been owed had she not rolled her gain into an Opportunity Zone.
In addition, because Cindy held her Opportunity Zone investment for at least 10 years, the appreciation of her investment of $215,402 will be tax-free when it is sold on January 1, 2029. Thus, Cindy realizes a tax savings of $51,266 ($215,402 of appreciation multiplied by the assumed 23.8 percent tax rate) in addition to the savings of $7,140 on the original $200,000 investment described above.
Three types of Qualified Opportunity Zone property
Qualified Opportunity Zone property can be in the form of stock, a partnership interest, or certain tangible business property.
1. Qualified stock and partnership interests
Stock of a domestic corporation or partnership interests of a domestic partnership qualify as Opportunity Zone property if:
- They were acquired by a qualified opportunity fund after December 31, 2017, at original issue, solely for cash;
- At the time of issuance, the corporation or partnership was a Qualified Opportunity Zone business (or, in the case of a new corporation or partnership, was organized for the purpose of being a Qualified Opportunity Zone business); and
- During substantially all of the fund’s holding period for such stock or partnership interest, the corporation or partnership met the requirements of a Qualified Opportunity Zone business.
2. Qualified Opportunity Zone business property
Qualified Opportunity Zone business property means tangible property used in a trade or business of a qualified opportunity fund if:
- The property was acquired by the fund by purchase after December 31, 2017;
- The original use of the property in the Opportunity Zone begins with the qualified opportunity fund or the fund substantially improves the property; and
- During substantially all of the fund’s holding period, substantially all of the use of the property was in a Qualified Opportunity Zone.
3. Qualified Opportunity Zone business
A Qualified Opportunity Zone business is a trade or business in which substantially all of the tangible property owned or leased by the business is Qualified Opportunity Zone business property, as described above. In addition:
- The trade or business must generate at least 50 percent of its total gross income from the active conduct of business;
- A substantial portion of the intangible property of the business must be used in the active conduct of business;
- Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity must be attributable to nonqualified financial property; and
- The business cannot be a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any business selling alcoholic beverages for consumption off premises.
Opportunities for developers and investors
According to an article from the Economic Innovation Group, U.S. investors are sitting on more than $2 trillion in unrealized capital gains from stocks and mutual funds alone, yet little of this capital has been directed into low-income communities. Investors seeking to cash out of successful positions for a new long-term investment opportunity now have the additional incentive of tax deferral and tax-free appreciation when they invest in an Opportunity Zone.
By creating qualified opportunity funds, developers put themselves in a position to use the prospect of significant tax savings and improved cash to encourage investment in their projects, while also fostering community redevelopment and economic stimulation.
How we can help
Whatever road leads you to Opportunity Zones, CLA is right there with you. Our wealth advisors are working closely with our business tax planning professionals to bring investors and developers together to realize the full benefits of the Opportunity Zone program. We take a proactive approach to income tax planning and financial planning that focuses on your long-term objectives. When you help us understand your goals, we can help you find opportunities.