The Opportunity Zone Program, established by the 2017 tax reform legislation—commonly referred to as the Tax Cuts and Jobs Act (Pub. Law 115-97)—seeks to encourage long-term investment in low-income communities.
If applied correctly, the Opportunity Zone Program may provide ways for property owners to reduce their overall tax burden. However, there are still several questions about the funds, how to determine if you qualify, and how to effectively invest.
New Internal Revenue Code Sections 1400Z-1 and 1400Z-2 allow taxpayers to defer and reduce capital gains from the sale or exchange of property by investing the gain into a Qualified Opportunity Fund (QO Fund) within 180 days of the exchange. These funds must be invested, directly or indirectly, into property located in designated Qualified Opportunity Zones (QOZ).
If you already have material gains from the sale or exchange of property in 2018, or anticipate material gains in the future, investing in QO Funds may be a strategic tool to lower your overall tax burden. However, the IRS hasn’t yet released regulations, so some specific details of the program aren’t yet available.
Here are the most common questions related to QOZs.
What’s a QOZ?
A QOZ is a designated area that’s been nominated by the state and approved by the IRS. The CEO or governor of each state and US territory nominated up to 25% of its low-income community census tracts as QOZs. The Department of Treasury then designated nominated tracts as QOZs. From that information, the IRS issued Notice 2018-48, listing all designated QOZs in all states.
A map and list of designated funds can be found here.
What benefits do QOZs provide?
The program provides the following three incentives for taxpayers who invest gain from a sale or exchange of property into a QO Fund.
- Taxpayers may elect to defer capital gains in an unlimited amount from the sale or exchange of any property to an unrelated person by investing the capital gain amount in a QO Fund. For qualified investments, the capital gain isn’t recognized until the taxpayer sells its interest in the QO Fund, or until December 31, 2026—whichever comes first.
- Investors may receive a reduction of capital gains related to the sale of QO Fund investments. At the time of the investment, the basis in the property is zero, meaning capital gains must be fully recognized when the taxpayer sells the interest.
If the investment is held for five years, the basis is increased to 10% of the amount of the investment, resulting in a 10% reduction in the capital gain recognized. If the investment is held for seven years, the basis increases to 15% of the amount of the investment, resulting in a 15% reduction in capital gain. Note that these reductions apply only to the original amount of the investment; capital gain is recognized on any appreciation of the fund.
- If investments are held for at least 10 years, the basis of the investment equals the fair market value at the time of sale. If the investment is sold after December 31, 2026, capital gain will have already been recognized. In that case, there’s no gain recognized on the appreciation in the QO Fund.
As an example of these three benefits, suppose a taxpayer sells property on October 1, 2018, realizes a capital gain of $100,000, and invests that $100,000 into a QO Fund on January 1, 2019. The investment is later sold for $125,000. The following facts apply based on the dates that it’s sold:
- Before January 1, 2024. The taxpayer only receives a deferral of capital gain.
- Between January 1, 2024, and January 1, 2026. The taxpayer recognizes capital gain of $115,000, which is 90% of the original investment of $100,000 plus $25,000 of appreciation.
- Between January 1, 2026, and December 31, 2026. The taxpayer recognizes capital gain of $110,000, which is 85% of the original investment of $100,000 plus $25,000 of appreciation. Note that $85,000 will be recognized on the date the investment is sold, or on December 31, 2026—whichever is earlier.
- After December 31, 2026. The taxpayer recognizes capital gain of $85,000 on December 31, 2026, which is 85% of the original investment of $100,000. There’s no gain recognized on the $25,000 of appreciation.
What’s a QO Fund?
A QO Fund is a corporation or a partnership organized for the purpose of investing in QOZ property. The corporation or partnership must hold at least 90% of its assets in QOZ property, determined by the average of the percentage of QOZ property held by the entity as measured:
- On the last day of the first six-month period of the taxable year of the fund
- On the last day of the taxable year of the fund
The IRS is expected to issue forms in summer of 2018 that allow eligible taxpayers to self-certify as QO Funds.
What does QOZ property generally include?
QOZ property includes any of the following types of property:
- QOZ business property.
- QOZ stock of a corporation, acquired at its original issue solely in exchange for cash. Substantially all of the tangible property owned or leased by the corporation must be QOZ business property.
- QOZ partnership interest, acquired solely in exchange in cash. Substantially all of the tangible property owned or leased by the partnership must be QOZ business property.
It’s worth noting that for QOZ stock and QOZ partnership interests, at least 50% of the business’s total gross income must come from the active conduct of the business. A large portion the business’s intangible property use must also take place in the active conduct of such business, and less than 5% of the average of the aggregate unadjusted bases of the business’s property must be attributable to nonqualified financial property.
What’s QOZ business property?
Generally, QOZ property is either QOZ business property or stock or interest in an entity that holds QOZ business property. QOZ business property is generally tangible property used in a trade or business that meets the following criteria:
- The property was purchased or newly constructed after December 31, 2017, generally from an unrelated party or a business that’s not part of the same controlled group.
- The property’s original use in the QOZ began with the QO Fund, or the property must be substantially improved, meaning during any 30-month period beginning after the date of acquisition, additions to basis with respect to the property need to exceed an amount equal to the adjusted basis of the property at the beginning of that 30-month period.
- Nearly all of the property’s use takes place in a QOZ during the property’s holding period.
We’re Here to Help
We’ll provide updates on this topic as the IRS releases further guidance. In the meantime, if you’d like to learn more about how you or your business can best benefit from the Opportunity Zone Program, please contact your Moss Adams professional or email firstname.lastname@example.org.