The 2017 Tax Act is offering a limited-time opportunity for taxpayers to defer gain on the sale of assets, reduce the gain when finally recognized and even eliminate gain on certain new investments. This is all made possible under the 2017 Tax Act by investing in "Qualified Opportunity Zones," a new provision that allows taxpayers to free up capital gains and reinvest those gains in economically distressed communities.
What is a Qualified Opportunity Zone?
A Qualified Opportunity Zone is a designated low-income community census tract. These zones have already been designated by the IRS, with nearly 9,000 throughout the United States, including almost 300 in New York City.
What are the benefits?
A taxpayer can sell property anytime through the end of 2026 to an unrelated party at a gain, and this gain will not be currently taxable if the amount of the gain is reinvested in a Qualified Opportunity Fund within 180 days of the sale. Unlike the existing like-kind exchange rules, only the gain needs to be reinvested, not the total sale proceeds.
The gain that was not currently taxed will be deferred until the date that the Qualified Zone investment is sold, or December 31, 2026, whichever comes first. Note that even if the property is not sold by the end of 2026, the taxpayer will still be required to recognize the gain that was deferred.
If the investment in the Qualified Zone is held for at least five years, then the taxpayer will receive a basis adjustment, such that 10% of the deferred gain will be eliminated. If the investment in the Qualified Zone is held for at least seven years, an additional 5% of the deferred gain will be eliminated, for a total reduction of 15% of the gain.
If a Qualified Zone investment is held for at least ten years, then the taxpayer may elect to completely eliminate the tax on the gain that relates to appreciation during the time the investment was held in the Qualified Opportunity Fund. Note that to hold a Qualified Zone investment more than ten years will take the investor beyond 2026, meaning that the deferred gain that was rolled into the Qualified Opportunity Fund will be recognized at the end of 2026, but any gain attributable to appreciation of the Qualified Opportunity Fund investments can be eliminated after ten years.
Investments in a Qualified Opportunity Fund may be made from sources other than a reinvestment of gains from the sale of property, but only the reinvested gains will be eligible for the benefits above, (i.e., the five and seven year basis adjustments and the ten year elimination of gain).
How do I get this benefit?
To avail yourself of these benefits, the investment of the deferred gain must be put into a Qualified Opportunity Fund. Such a fund must be either a corporation or partnership formed for the purpose of investing in Qualified Opportunity Zone Property. The IRS has indicated the fund will self-certify, with an IRS form expected to be issued soon.
In addition, a Qualified Opportunity Fund must hold at least 90% of its assets in "Qualified Opportunity Zone Property," (defined below). This will be measured as the average of June 30 and December 31 balances each year, or comparable dates for fiscal year taxpayers. There will be a penalty for the failure to consistently meet the 90% threshold.
Qualified Opportunity Zone Property consists either of (1) Qualified Opportunity Zone Stock, (2) Qualified Opportunity Zone Partnership Interests or (3) Qualified Opportunity Zone Business Property.
Qualified Opportunity Zone Stock is stock of a domestic corporation acquired by the Qualified Opportunity Fund after 2017 from the issuing corporation solely for cash. Such corporation must be a Qualified Opportunity Zone Business during substantially all of the Qualified Opportunity Fund's holding period of the stock.
Qualified Opportunity Zone Partnership Interest is an interest in a domestic partnership acquired by the Qualified Opportunity Fund after 2017 from the partnership solely for cash. Such partnership must be a Qualified Opportunity Zone Business during substantially all of the Qualified Opportunity Fund's holding period of the partnership.
A Qualified Opportunity Zone Business, which is required for either Qualified Opportunity Zone Stock or Qualified Opportunity Zone Partnership Interests, is a trade or business in which substantially all of the tangible property owned or leased by the entity is Qualified Opportunity Zone Business Property (defined below) and which meets several additional requirements:
(a) At least 50% of the gross income of the business must be from an active trade or business;
(b) A substantial portion of any intangible property must be used in the active conduct of the business;
(c) Less than 5% of the assets can be in "nonqualified financial property" (e.g., stock, debt instruments, etc.);
(d) The business does not include a golf course, country club, massage parlor, hot tub or suntan facility, racetrack, casino or liquor store.
Qualified Opportunity Zone Business Property is tangible property that was acquired by purchase after 2017 and that is used in a trade or business of the Qualified Opportunity Fund. The original use of the property must either begin with the Qualified Opportunity Fund or the Qualified Opportunity Fund "substantially improves" such property. Property is "substantially improved" only if, during the 30-month period after acquisition, the additions to basis by the Qualified Opportunity Fund exceed the Fund's basis in the property at the beginning of the 30-month period (i.e., you must spend at least as much as the property's pre-improvement basis in order for the improvements to be deemed "substantial"). During substantially all of the Qualified Opportunity Fund's holding period, substantially all the use of the property must be in in a Qualified Opportunity Zone.
How do I proceed?
As you can see, there are many definitions and tests involved in qualifying for these tax benefits. Unfortunately, there are ambiguities in the law and unresolved questions as to how these rules will operate; to that end, we await regulatory guidance from the Treasury Department addressing many key issues, which is expected later this year.
In the meantime, we can advise you on how to maximize the tax benefits when planning investments in the U.S. after 2017 and to consider whether new Qualified Opportunity Zone tax incentives may enhance anticipated returns, particularly in real estate investments where substantial improvement may be demonstrated clearly. For developers whose decisions include site selection, checking suitability of designated Qualified Opportunity Zones would seem prudent and straightforward. The tax deferral and tax reduction aspects of Qualified Opportunity Zones offer significant potential for enhanced returns. For asset managers or others considering Qualified Opportunity Fund formation, the anticipated clarification to be provided by the Treasury Department seems a prerequisite to launching a new Qualified Opportunity Fund, but it is not too soon to consider the structuring issues involved in setting up a new fund.