Included as part of the 2017 tax reform bill the Tax Cuts and Jobs Act, Opportunity Zones present a new and potentially lucrative tax deferral strategies for certain taxpayers. Taxpayers have the potential to defer current capital gains, potentially eliminate a portion of this gain and no taxable gains on the investments in the Opportunity Zones. However, investments in these vehicles may not be best for everyone, as they will require certain types of income and the ability to hold these otherwise illiquid investments for a long time to maximize benefits.
Opportunity Zones are state identified, economically-distressed communities where capital has been scarce for new investments. The thought was to create a tool to permit more capital to flow to the low-income communities across the United States. In order to invest in an Opportunity Zone, a taxpayer would invest in a new investment vehicle, called a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is in an Opportunity Zone and utilizes the investors capital gains from a prior investment for the funding of these activities.
Investing in a QOF offers significant tax incentives to investors, primarily in the form of tax deferral on the gains, potential elimination of realized gains, and no taxable gain on the disposition of the QOF investments.
In order to qualify for deferral, a taxpayer must first have had a capital gain transaction, such as those from the sale of stocks or property. In order for a taxpayer to take advantage of this deferral, they would need to reinvest the realized capital gain with 180 days into a QOF. The deferral period lasts until the earlier of December 31, 2026 or until the investment has been sold or exchanged, whichever is earlier.
Potential Elimination of Realized Gains
Once the realized gain has been invested into a QOF, the taxpayer may be able to eliminate some of this realized gain via a “step-up” in basis. The first milestone is five years. After 5 years, 10% of the realized gain is “stepped-up” in basis, thereby eliminating 10% of the gain. The next milestone is 2 years, afterward another 5% of “step-up” is granted, bringing the total gain that may be eliminated up to 15%.
Permanent Exclusion of QOF Gains
On top of the already generous deferral period and elimination of realized gains, QOFs can offer a second “step-up” transaction related to the investment in the QOF itself, for the gains that occur after the investment into the QOF. In order to receive this benefit, a taxpayer must hold their investment in the QOF for 10 years, after which taxpayers are given a 100% “step-up” in basis when the investment is sold or exchanged.
Qualified Opportunity Funds (QOF)
As mentioned, a QOF is a corporation or a partnership that invests its assets (90% or more) in Opportunity Zone Property. This includes tangible property (think real estate) located in the Opportunity Zone. The property must either be new to the Opportunity Zone or “substantially improved” within 30 months of purchase for used property. An entity becomes a QOF by completing Form 8996 and self-certifying that 90% of its property meets the definition of Opportunity Zone Property. Investors who are interested in investing should decide if they would rather try and create and manage their own fund or invest in a fund that is being promoted by investment agencies.
Despite the appeal of these investment vehicles, there remains risks that are a part of all investments. There is no guarantee of gains in the fund, and the long holding period and illiquid nature of the investment may prove too big of barriers to entry for many investors. However, there are significant tax benefits available for certain taxpayers that may make this an opportunity worth exploring further.
Edward McWilliams, CPA
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.
Kayla Vigorito, MBA
Kayla is a member of Cerini & Associates’ tax staff which provides services across a variety of industries including healthcare, construction, retail, manufacturing, service, and technology.