The Tax Cuts and Jobs Act created a new tax incentive to defer (and possibly even eliminate) capital gains taxes by investing in a Qualified Opportunity Zone (QOZ).
What is a Qualified Opportunity Zone?
A Qualified Opportunity Zone is an economically distressed community. For an area to be recognized as a Qualified Opportunity Zone, the state must nominate the area and the Secretary of the US Treasury must certify the nomination. An investment in a Qualified Opportunity Zone is expected to result in the creation of jobs and quality-of-life improvement for residents of low-income communities.
What is a Qualified Opportunity Zone Fund and Who Can Invest in One?
A Qualified Opportunity Zone fund invests in eligible property located within a Qualified Opportunity Zone. It is either a corporation or partnership for income tax purposes, must be in the United States, and must be at least 90% invested in Qualified Opportunity Zone businesses or property. Individual taxpayers, S and C corporations, partnerships, trusts, estates, RICs (regulated investment company), and REITs (real estate investment trust) are eligible to invest in a Qualified Opportunity Zone fund.
How Does the Program Work?
A taxpayer has 180 days from the date of sale of appreciated property (can be stocks, real estate, etc.) to invest the capital gain into a Qualified Opportunity Zone fund.
Example: John Smith sells stock for $100,000. His basis is $5,000, making his gain of $95,000 fully taxable. If he reinvests the sale proceeds into a Qualified Opportunity Zone fund within 180 days of the sale, he can elect to defer his $95,000 gain until he sells his interest in the Qualified Opportunity Zone fund or December 31, 2026 (IRC code 1400Z-2(b)(1)), whichever comes first.
What is the Benefit of Deferring Capital Gains?
After remaining in the fund for five years, the taxpayer receives a 10 percent reduction in the deferred gain that will be subject to tax. Then, he/she is eligible to receive an additional five percent deferred gain reduction after seven years of investment (for a total of 15 percent). To take advantage of the full 15 percent reduction, the taxpayer must invest in a Qualified Opportunity Zone fund by 12/31/2019. For example, a taxpayer who invests $100,000 of capital gains from a previous investment into a Qualified Opportunity Zone fund in 2019 would owe capital gains tax on only $90,000 if sold after five years and $85,000 if sold after seven years.
Although the gain can only be deferred until the earlier of the sale date of the interest in a Qualified Opportunity Zone fund and December 31, 2026, at which point tax must be paid on that original deferred gain regardless, there is another possible benefit. If a taxpayer remains in the Qualified Opportunity Zone fund for at least 10 years, 100 percent of any gain on his/her investment in the fund is tax-free. In other words, if the investment is held for at least 10 years, upon sale the taxpayer will pay NO tax on any capital gains produced through his or her investment in the Qualified Opportunity Zone fund! This is a great opportunity to achieve long-term, tax-free growth on your initial investment!
Does Your State Conform?
Not all states have incorporated the Opportunity Zone gain deferral provisions, and taxpayers may have to recognize the gain on their state tax return when the original investment is sold. If you would like to know more about Qualified Opportunity Zones, please reach out to us anytime.