Understanding Qualified Opportunity Zones

As part of an overhaul to the Tax Code, the Tax Cuts and Jobs Act of 2017 introduced a new tax-advantaged savings vehicle through the use of Qualified Opportunity Zones (“QOZ”). By reinvesting capital gain proceeds into a Qualified Opportunity Fund (“QOF”), investors can temporarily defer recognizing income tax on those gains, can receive a basis step-up in their investment, and may be able to permanently exclude capital gains on the appreciation of the investment if held for 10 years.

The rules on Qualified Opportunity funds are complex, and additional guidance from the IRS is forthcoming. If you have any questions about Qualified Opportunity Zones, please do not hesitate to contact our offices.

 

What is A Qualified Opportunity Zone?

A QOZ is an economically distressed area or community that has been nominated as such by each state or territory and has been certified as such by the Treasury Department. A map of Kentucky opportunity zones may be found here: http://www.thinkkentucky.com/OZ/

 

What is A Qualified Opportunity Fund?

A QOF is an investment vehicle (corporation or partnership) formed to invest in QOZ property. The fund must hold at least 90% of its assets in QOZ property to maintain its status as a QOF. QOZ Property, in turn, is stock or partnership interests of a QOZ business, or QOZ business property.

A QOZ business is an active trade or business in which substantially all of the assets owned or leased are QOZ business property. At least 50% of the business’ gross income must be generated from the active conduct of the business. Certain businesses, such as country clubs, racetracks, or liquor stores, are ineligible to be a QOZ business.

QOZ business property is tangible property used in a trade or business that was purchased after 12/31/17. The original use of the property must begin with the trade or business, or most be substantially improved within 30 months of purchase. To be considered substantially improved, additions to the basis of the property must exceed the adjusted basis of the property.

 

How is A Qualified Opportunity Fund Formed?

To become a QOF, the entity self-certifies by completing Form 8996, Qualified Opportunity Fund and attaching it to the entity’s timely filed Federal tax return. This form is also used to report compliance with the 90% asset test on the 6th and final month of the fund’s tax year.

 

What are the Tax Implications of Investing in a QOF?

Within 180 days of a sale or exchange of capital property, an investor can take any amount of capital gain proceeds and invest them in a QOF. Doing so offers three distinct tax advantages:

Tax Deferral on Invested Gain. The investor will not be required to recognize income tax on the capital gain proceeds invested in a QOF until the earlier of (1) the tax year in which the investment is sold or exchanged, or (2) December 31, 2026. The amount to be included is equal to the lesser of the deferred gains or the FMV of the investment, decreased by the investor’s basis in the investment. The investor’s basis in his or her investment will then be stepped up by the amount of gain recognized.

Basis Increase of Invested Gains. The investor’s basis in his or her investment in a QOF is initially zero. If an investor holds an investment in a QOF for five years, he or she will receive a 10% basis step-up in the deferred gains. If the investor holds the investment for two more years, he or she receives an additional 5% step-up. Thus, if an investment in a QOF is held for seven years, the investor receives a 15% basis step-up in his or her deferred gains. This step-up effectively reduces the amount of the initial invested proceeds that will be subject to tax once the deferral period ends.

Tax Free Appreciation of QOF Investment. If an investor holds a QOF investment for at least 10 years, his or her basis in the investment will be treated as equal to the fair market value of the investment on the date of its sale or exchange. Accordingly, holding a QOF investment for 10 years will allow the investor to receive any appreciation in the value of his or her investment tax-free.

 

Example Illustrating Tax Advantages of QOF Investment

On January 1, 2018, Tom and Pam sell stock with a FMV of $1,500,000 and a cost basis of $500,000. Within 180 days of the sale, Tom and Pam invest the $1,000,000 capital gain into a QOF in exchange for shares of the QOF. They hold their investment until 2029 and sell when the FMV of their investment is $2,000,000. The tax consequences are as follows:

  • In 2023, because they have held the investment for five years, their basis in their deferred gains is increased by 10%, to $100,000.
  • In 2025, because they have held the investment for seven years, their basis in their deferred gains is increased by an additional 5%, to $150,000 total.
  • For 2026, they are required to include in income $850,000 of capital gains. This is equal to the original amount of gain deferred ($1,000,000) less their increased basis in the deferred gains ($150,000). At this point, their basis in their investment is stepped up to $1,000,000 (the basis in their deferred gains plus the amount included in income)
  • In 2029, when their QOF investment is sold, Tom and Pam do not recognize tax on the $1,000,000 in gain ($2,000,000 FMV less $1,000,000 basis). This is because they have held the investment for more than 10 years.

 

Sources: 26 U.S.C.. 1400Z-2; NPRM REG-115420-18, Internal Revenue Service (Oct. 22, 2018); https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions

The statements contained herein are not intended to constitute written tax advice within the meaning of IRS Circular 230 §10.37. These statements are solely intended to communicate general information for discussion purposes and should not be interpreted as written tax advice nor should they be relied on as such. If you would like to speak with someone in our office regarding the content in this article, please contact us at 502-753-0609 and we will be happy to assist you.

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