There is a great deal of interest in the new opportunity zone tax incentive that was created as part the Tax Cuts and Jobs Act of 2017. Opportunity zones allow private investors the opportunity to reinvest their profits in low-income, rural, and suburban areas in the country for potential preferential tax treatment.
Below we have outlined the proposed regulations for the Qualified Opportunity Zone (QOZ). Keep in mind that there may be changes when the final regulations are issued.
- The new proposed regulations for Qualified Opportunity Zones (QOZ) defer taxation of eligible gains (which are capital gains) for federal income tax purposes when those gains are reinvested into a qualified opportunity fund (QOF) within 180 days of the sale or exchange that gives rise to the gain:
- after holding the interest in the QOF for five years, 10% of the original deferred gain can be excluded;
- after holding the interest in the QOF for seven years, 15% of the original deferred gain can be excluded;
- any remaining deferred gain is recognized on December 31, 2026. If the interest in the QOF is sold after a holding period of 10 years, the remaining gain on the QOF investment is tax-free.
- If the partnership or S corporation wants to defer taxation of eligible gain, it must reinvest the gain into a QOF within 180 days from the date of the sale/exchange that gives rise to the gain. If the partnership or S corporation allocates the deferred gain to its owners, the 180-day period concerning the owners’ eligible gains begins on the last day of the entity’s tax year (i.e., generally December 31).
Related Blog: Opportunity Zones Create Tax Breaks for Private Investors, Benefit Distressed Communities
- The current maximum capital gain tax rate is 23.8% (including the net investment income tax of 3.8%). The capital gain tax rate after 2026 is unknown and could change before then depending on the outcome of future elections. Thus, if taxation of a capital gain is deferred by investing in a QOF, it could be taxed at a higher rate in the future.
- To maximize the tax benefits available under the proposed regulations for QOZs, the eligible gain should be reinvested into a QOF, which can be a C corporation, S corporation, or partnership, before December 31, 2019.
- The remaining deferred gain will be triggered at the end of 2026 or at the time of the sale of the investment, whichever is earlier. Sufficient funds need to be prepared for the tax liability.
- When you sells your interest in the QOF after 10-year hold, the gain from the future appreciation of your investment in the QOZ including any recapture, i.e., the gain in excess of the deferred gain, will be completely tax-free. That’s a home run! However, if the QOF sells its assets after 10-year hold, the partner/shareholder can only make the election to exclude the capital gain allocated to them on Schedule K-1 resulting from the sale of QOZBP. Also, if the sale of the assets is subject to recapture, they would be recognized by the partner/shareholder.
- From the tax benefit point of view, it may be advisable to invest only up to the amount of the eligible gain in the QOF because there’s no additional benefit for those investments. It would create complexity and confusion in the investment because a separate tracking system is needed for the QOZ (deferred gain) and non-QOZ (additional amounts in excess of the deferred gain) investments in one QOF.
- A partnership can be the QOF itself if all partners are on board. The sale of a Section 1231 asset is eligible to be reinvested into a QOF. Only net Section 1231 gains netted with other Section 1231 losses are treated as capital gain. Because the character of the Section 1231 gain is determined only at the partner level, if the partnership passes the deferred gain to its owners, they will have to wait until the end of the tax year when the Section 1231 gain netting process is complete. The regulations provide for the 180-day reinvestment period beginning on December 31, 2019.
- Taxpayers would be required to retain any written plan in their records for acquisition, construction, and/or substantial improvement of tangible property in a QOZ. The working capital will be completely consumed in a manner that is substantially consistent with the plan no later than 31 months after the amounts are first invested in eligible interests in the relevant QOF.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.