Time Is Running Out for Full Benefits of Opportunity Zone Investment: Does It Matter?
Tax reform added attractive tax deferral and exclusion incentives for investing capital gains in a qualified opportunity zone fund (QOF) during a 180-day period, which includes:
- Deferral of the reinvested gain until the earlier of:
- The day the QOF is sold or exchanged, and
- December 31, 2026.
- Permanent exclusion of up to 15% of the deferred gain if the QOF is held for at least seven years by December 31, 2026. In other words, you may only have to pay tax on 85% of the deferred gain when that gain is eventually recognized.
- No exclusion of the deferred gain is available if the QOF is not held at least five years and a 10% exclusion is available if the QOF is held at least five years but less than seven years.
- Permanent exclusion of post-investment appreciation in the QOF if the investment is held at least 10 years.
The QOF investment must occur no later than December 31, 2019, for you to be able to satisfy the seven-year holding period requirement for the full 15% gain exclusion. If you have a gain that falls into one of the three categories below, your 180-day investment may include December 31, 2019, and a portion of 2020; in that case, timing your QOF investment to occur in 2019 will allow you to qualify for the 15% exclusion. Here are the three categories:
- Capital gain realized between July 5, 2019, and December 31, 2019. For example, the 180-day period for an individual who sells land held for investment on October 31, 2019, runs from October 31, 2019, to April 27, 2020.
- Net section 1231 gains realized any time during a tax year ending between July 5, 2019, and December 31, 2019. For example, the 180-day period for a net Section 1231 gain realized by a calendar-year individual on January 1, 2019, begins December 31, 2019, and runs through June 27, 2020.
- Capital and net Section 1231 gains reported on Schedule K-1 from a pass-through entity, such as a partnership or S corporation, whose tax year ends between July 5, 2019, and December 31, 2019. For example, the 180-day period for an individual who is allocated capital gain from a partnership with a tax year ended October 31, 2019, runs from October 31, 2019, to April 27, 2020, under the general rule.
Perhaps more important than qualifying for the 15% exclusion is making sure you make the right financial decision for you; don’t feel pressured to make an investment out of fear of missing out on the exclusion. The following example illustrates this point:
Abigail owns an interest in AB LP. AB LP is a calendar-year partnership that generates a capital gain on February 1, 2019. AB LP chooses not to defer the gain by investing in a QOF, so the capital gain will pass through to the partners on Schedule K-1. Under the general rule, Abigail can elect to defer her share of AB LP’s gain by investing the gain in a QOF during the 180-day period beginning on the last day of AB LP’s tax year, December 31, 2019. If Abigail makes the QOF investment on December 31, 2019 (no earlier and no later) and continues to hold her investment on December 31, 2026, Abigail can permanently exclude 15% of the deferred gain. AB LP must inform Abigail of her share of AB LP’s capital gain so that Abigail can make the investment by December 31, 2019; if Abigail waits until she receives the 2019 Schedule K-1, the 15% gain exclusion won’t be available but may be eligible for the 10% exclusion. Regardless of when she receives the Schedule K-1, the 180-day period begins to run December 31, 2019. It expires on June 27, 2020.
Abigail’s share of the partnership capital gain is $1 million. If Abigail invests $1 million in a QOF, the 15% exclusion for holding the QOF at least seven years is $150,000 if the QOF investment is made in 2019 and $100,000 if the investment is made in 2020. (An investment in a QOF greater than her capital gain provides no additional Opportunity Zone tax benefit.) The additional $50,000 exclusion will save about $12,000 in tax in 2026 assuming a 23.8% rate. While $12,000 is real money, it is relatively small compared to the $1 million investment, so it is more important to find the right investment than to make the investment by December 31, 2019. Of course, if Abigail is able to find an attractive investment that works well for her before December 31, 2019, she might as well time the investment to qualify for the additional exclusion.
Pass-through entities with a tax year that ends between July 5, 2019, and December 31, 2019, should let their owners know as soon as possible the amount of capital gains or net Section 1231 gains they anticipate allocating to each owner on Schedule K-1. This allows the owners to begin evaluating whether a QOF investment is right for them.
How we can help
Opportunity Zones provide incentives that can enhance after-tax investment returns for the well-advised but traps for the unwary. Our business tax planning professionals and wealth advisors are immersed in the real estate field, investment market, tax reform, and our clients’ industries, so they can help you:
- Calculate the amount of gain eligible to be reinvested in a QOF.
- Determine the 180-day period during which the QOF investment can be made.
- Weigh the benefits of making a QOF investment on December 31, 2019, to potentially qualify for the 15% gain exclusion.
- Navigate the mechanics of making an investment on December 31, 2019, which can be tricky with the holidays.
At CLA, our goal is to help you make clear decisions so you can realize the full benefits of the Opportunity Zone program. Whatever road leads you to Opportunity Zones, CLA is right there with you.