If you’re looking to invest in economically distressed areas, you’ve got a new advantage—a tax break on capital gains thanks to qualified opportunity zones (QOZs).
Under the new tax legislation, people and companies investing in QOZs can defer recognition of capital gains from the sale of any capital asset until 2026. This includes the sale of stock, property or other investments, as long as the capital gains from the sales are invested in these zones.
Using qualified opportunity zones gives investors a chance to not only reap tax benefits, but also help build their communities and strengthen their economies—a win-win situation for everyone.
What is a Qualified Opportunity Zone?
An opportunity zone is an economically-distressed area designated specifically by each state. As long as investors meet certain requirements, they can defer or even exclude capital gains when the money is invested in real estate development, new construction, substantial renovation of existing property and qualifying businesses in a qualified opportunity zone. The designation was created to spur economic development in such regions by providing tax benefits to investors.
Taxpayers investing in these areas must place the capital gains in a qualified opportunity fund (QOF), a corporation or partnership formed to invest in qualified opportunity zone property. (A corporation or partnership files Form 8996 with the federal income tax return to self-certify that it is organized as a QOF.)
The QOF must hold at least 90% of its assets in such property within the first six months of the fund’s establishment. If this threshold is not met, substantial penalties are imposed. The IRS provides a safe harbor that allows cash to be held in the QOF for up to 31 months as long as there is a detailed written plan for the use of all funds.
What Are the Tax Benefits?
You can defer the capital gains from a sale or exchange if the gains are invested in a QOF within 180 days from the sale or exchange of the asset to an unrelated party. Additionally, you can invest less than the gain for partial deferral. Pass-through entities, such as partnerships, S-corporations, estates and trusts, can also invest in a QOF and make an entity-level election to defer gain recognized at the entity level or at the owner level.
Here are the specifics:
- Under the new program, you are only required to reinvest gains (not proceeds) from the sale of assets (stocks, land investment property, etc.). Only capital gains (short and long term) can be deferred, including unrecaptured Section 1250 gain.
- You can defer the gain until either the sale of the interest or December 31, 2026, whichever is earlier.
- There are ways to permanently defer some of the taxes on these gains, depending on how long the QOF is held:
- If the funds are held for five years, you can permanently exclude 10% of the deferred gain.
- If the funds are held for seven years, you can permanently exclude 15% of the deferred gain (property must be invested by December 31, 2019).
- If the funds are held for 10 years, future appreciation is permanently excluded. To obtain 100% exclusion of appreciation, all QOFs will be required to sell assets by the end of 2047.
- The deferred gain retains its character when recognized (short-term deferral would be short-term when recognized).
- You can deposit funds into a qualified opportunity fund for as long as 31 months if certain requirements are met.
Additional cash can be invested in the QOF, but it is not eligible for the ten-year exemption of appreciation. This would be treated as a separate investment in the QOF and tracked accordingly.
For example, a taxpayer has $10 million of cash from capital gains that was invested in a QOF, and he invests another $10 million of additional funds (from non-capital gain sources). In this example, half of the future appreciation will be excluded or stepped-up. These rules can be avoided by utilizing debt as an additional funding source. The new debt would not be treated as a separate investment and would qualify for 100% exclusion of the appreciation.
Are there other requirements?
Yes. One of two additional requirements outlined by the IRS must be filled:
- The original use of the QOZ property must begin with the establishment of the QOF (we are waiting for additional guidance from the IRS regarding the definition of “original use”); or
- Funds from the QOF must substantially improve the property within 30 months (improvements would need to exceed the cost of the property). Note that land is treated as qualifying property and not counted when determining whether the QOZ has been substantially improved.
What is the difference between a 1031 like-kind exchange and a qualified opportunity zone?
While these tax-saving methods are very similar, they have some key differences:
- A qualified intermediary is required for a 1031 exchange but not necessary for QOZ investment.
- Once you’ve elected to treat the fund as a QOF, a subsequent 1031 exchange is not allowed.
- The deferral of gains from a 1031 exchange are not recognized until the property is sold or deferred with a subsequent 1031 exchange.
- The deferral of gains using a QOZ must be recognized by the end of 2026, even if the property is still held.
- The deferral of gains under a 1031 exchange is not permanent, whereas a portion of the deferred gains using a QOZ can be permanent.
Thanks to qualified opportunity zones, you can reduce your tax burden while you support the positive development of your community. James Moore’s business tax CPAs can help you identify QOZs in your area, manage related investments, set up qualified opportunity funds and more. You can also visit the U.S. Department of the Treasury’s website to download a spreadsheet or use an interactive map to find the zones nearest to you.
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