By Bennett Dean, CPA
As the United States continues to cope with the economic effects of the COVID-19 pandemic, a tax incentive created in the Tax Cuts and Jobs Act (“TCJA”) has the potential to provide relief to some of the hardest hit communities and businesses. That incentive is the Qualified Opportunity Zone (QOZ or OZ), which is a federal economic tax benefit designed to promote long-term, private investment and spur economic development in low-income communities.1 It aims to achieve this investment and development through the preferential treatment of certain capital gains that are invested in these low-income communities.
But what exactly are Opportunity Zones, what are the tax benefits for investors, and how will the new political environment affect this tax incentive?
Background and intent
In general, Opportunity Zones, which are defined in IRC Sections 1400Z-1 and 1400Z-2, are low-income census tracts that have been designated by the U.S. Treasury Department to receive tax-favored capital investment. The goal was and is to increase investment in areas that have been largely overlooked by private investors, with the ultimate aim of leveling the economic playing field for those who have historically been at a disadvantage.
Each state was allowed to choose its own zones for designation, with the idea being that the states themselves had better insight into communities that needed additional support. In total, approximately 8,700 Opportunity Zones were designated by Treasury across the United States, with 212 in Virginia.
To be eligible for Opportunity Zone tax benefits, taxpayers must invest in ventures that primarily conduct business in an Opportunity Zone. This will usually be done through an investment vehicle called a Qualified Opportunity Fund (QOF), which is an entity organized as a partnership or corporation with the purpose of investing in Qualified Opportunity Zone Property.2
There are three primary tax benefits available to investors in QOFs (discussed in more detail below): 1) deferral of gain; 2) basis step-up; and 3) exclusion of appreciation.
This article focuses on these three tax benefits. The rules and criteria concerning Qualified Opportunity Zone Property, Qualified Opportunity Zone Businesses and Qualified Opportunity Zone Business Property are outside the scope of this article.
The three federal tax benefits of OZs
Deferral of capital gains
The most readily attainable and immediate tax benefit is the deferral of capital gains. A taxpayer who has eligible gains can elect to defer those gains if they are rolled over and invested in a qualified opportunity zone within a 180-day investment period. There are several statutory rules and definitions that must be reviewed and understood to make sense of this deferral benefit.
First, eligible gains are generally any gains that would be treated as capital gains on the taxpayer’s return. This includes Section 1221 gains from the disposition of capital assets (for instance, stocks) or Section 1231 gains from the sale of property used in a trade or business. It also includes capital gain distributions from corporations (typically reported to taxpayers on a Form 1099-DIV). However, eligible gains do not include any gain that is required to be treated as ordinary income, so any gain recaptured under Section 1245 would not be considered an eligible gain. Another caveat — an eligible gain cannot be from a sale or exchange with a related party.
Furthermore, while it is usually necessary to net capital gains and capital losses, and Section 1231 gains and losses, on a taxpayer’s return, under the final Opportunity Zone regulations a taxpayer’s eligible gain can be determined without regard to any losses.3 If this method is chosen, the 180-day investment period (discussed next) begins on the sale date rather than the end of the year.
After recognizing an eligible gain, taxpayers have 180 days to take that gain and reinvest it in a QOF. Usually, this is 180 days after the sale that triggered the gain, but in certain cases, the start of the 180-day investment period is delayed. For example, partners or shareholders in a pass-through entity can choose to start the 180-day investment period on the due date of the entity’s tax return (not including extensions).4
The election to defer the eligible gain is made on the taxpayer’s income tax return on Form 8949. The instructions to Form 8949 describe how to make the election. The entire gain from a specific sale is not required to be deferred, and a partial gain can be deferred. Once the election to defer the eligible gain is made, though, the basis in the “new” QOF investment is zero. Starting in 2019, taxpayers who defer an eligible gain and hold a QOF investment will have to disclose that investment on Form 8997, which is also filed with the taxpayer’s federal income tax return.
As is the nature of a deferral, it does not last forever. The deferred gain will have to be recognized by the taxpayer eventually, and the date on which the gain becomes taxable is on the earlier of Dec. 31, 2026, or on an “inclusion event.” An inclusion event is one that reduces or terminates a qualifying investment in a QOF.5 Such an event would require the taxpayer to recognize part or all a deferred gain. Examples of inclusion events include a sale or exchange of the QOF interest or a gift of the QOF interest. If there is no inclusion event, the latest tax year to which an eligible gain can be deferred is 2026.
When the deferred gain is recognized in part or in whole, it is taxed at the applicable federal tax rate in place for that year, not at the tax rate when the gain was originally deferred. If capital gains tax rates go up prior to Dec. 31, 2026, it could increase the deferral benefit. This is discussed in more detail later.
The next tax benefit, the basis step-up, is an automatic adjustment that occurs after a QOF investment is held for five and seven years. For eligible gains that are reinvested in a QOF and held for at least five years in the QOF, the basis of the investment is stepped-up by 10% of the deferred gain.6 If the QOF investment is held for seven years, there is an additional 5% basis step-up, for a total basis step-up of 15%.7 It should be noted that if the Dec. 31, 2026, inclusion date arrives earlier than the five-year or seven-year investment “anniversary,” there is no basis step-up, and this benefit is lost. It is possible to have the 10% basis step-up for a five-year investment but miss out on the extra 5% for a seven-year investment, depending on when the eligible gains were reinvested in the QOF.
Exclusion of appreciation
The final tax benefit of Opportunity Zones is the permanent exclusion of any gain related to appreciation of the QOF investment, if the investment has been held 10+ years. The taxpayer can make a separate election to exclude any appreciation from gross income by stepping up the basis of the QOF investment to its fair market value. This won’t be an issue until 2028 at the earliest, however, due to the 10-year requirement.
There are two important factors to consider, however, regarding the exclusion:
- Only a qualified investment — one for which a deferral election was made — can receive the step-up to fair market value after 10 years. If gains other than eligible gains (e.g. ordinary gains) are invested in the QOF, or if no deferral election is made for eligible gains, then the basis adjustment to fair market value isn’t available for the investment. This would be considered a “non-qualifying investment.”
- While the first two tax benefits decrease in value as Dec. 31, 2026, draws nearer, the exclusion benefit retains its value. Qualifying investments made today are still eligible for the entire appreciation exclusion.
Below is a simplified example of how the three tax incentives would work for a taxpayer that held its QOF investment for 10+ years.
- Investor A realizes a $5M long-term capital gain on the sale of stock it has held for several years. A’s basis in the stock was $1M, and the stock was sold in late 2019 for $6M.
- A takes the $5M capital gain — note that it is not necessary to invest the $6M proceeds, just the amount of capital gain — and reinvests it in QOF B in December 2019.
- A elects to defer the $5M gain on its 2019 Form 8949 and reports the investment in QOF B on Form 8997.
- A keeps the $5M investment in QOF B through 2026. Absent any other inclusion event, on Dec. 31, 2026, A will recognize the deferred gain in its income.
- But A will have received a 15% step-up in basis, or $750,000 (10% for holding the investment for five years, plus another 5% for holding it seven years). A and will only be taxed on $4.25M of capital gain.
- Note that the maximum basis step-up of 15% requires that a taxpayer invests its eligible gains in a QOF by Dec. 31, 2019, to meet the seven-year requirement. To meet the 10% basis step-up after five years, the QOF investment needs to be made by Dec. 31, 2021.
- A continues to hold the investment in QOF B for another three years and has now held the investment for more than 10 years. A sells its interest in the QOF for $15M. Upon making a valid election to exclude any gain related to appreciation, the $10M gain on the QOF investment is not taxed.
- As noted previously, the deferral and reduction benefits decrease as Dec. 31, 2026, draws nearer, but the exclusion benefit for 10-year holding periods remains.
Changes on the horizon?
With a changing political environment and the need to address the economic impact of the pandemic, there will likely be changes to tax rates and tax policy in the coming years. How will this affect the nascent Opportunity Zones?
It is unlikely that they will go away entirely since they were one of the few tax provisions in the TCJA that received bipartisan support. However, there have been criticisms of the program and whether it is attracting the right kind of investment to the affected areas. Despite the fact that President Trump’s Council of Economic Advisors has estimated $52 billion of new investment in Opportunity Zones as a result of the program as of 2019, critics worry that new investment is focused on projects with higher returns. Such projects generally include luxury real estate developments that could drive out current residents, as opposed to affordable housing or community businesses.
Congress may look to Treasury to gather more data on the types of activity in Opportunity Zones to provide more transparency into the impact the new investments are having on the communities.
Of course, the one item on many minds is the potential for an increase in the capital gains tax rate. If capital gains rates do go up in the next few years, gains that have already been deferred and invested in QOFs would be tax at higher rates when there is a recognition event in the future. However, investors could look to trigger deferred gains before the rate increase is effective. If an earlier recognition of gains is deemed to be more beneficial than the potential appreciation of the QOF investment, there could be a mass exodus of funds from the QOFs.
On the other hand, a rate hike would add to the value of the gain deferral, at least through 2026, as the net present value of tax savings would increase.
In any event, Opportunity Zones can be a flexible and powerful tool, both as a tax-saving strategy for investors and as a means for states to direct investment to communities in need of support. With the economic fallout caused by the pandemic, it will be important to look for new ways to promote growth and recovery for those individuals and businesses hit the hardest. And Opportunity Zones have already been floated as one item that could be expanded for future stimulus or COVID relief.
Bennett Dean, CPA, is a tax director at PIASCIK, a premier provider of financial and tax services to a broad range of clients throughout the world, based in Glen Allen. He focuses on domestic and international tax consulting and compliance for both individuals and businesses.
- I.R.C. § 1400Z-2(d)(1)
- Treas. Reg. § 1.1400Z2(a)-1(b)(11)
- Treas. Reg. § 1.1400Z2(a)-1(b)(11)
- I.R.C. § 1400Z-2(b)(2)(B)(iii)
- I.R.C. § 1400Z-2(b)(2)(B)(iv)