By: Ryan Beethoven-Wilson, CPA, Tax Manager
While the drafters of the 2017 Federal Tax Cuts and Jobs Act were looking to revamp the tax code in a way that promoted fairness and simplification, community revitalization was also a consideration that impacted the final bill. With revitalization in mind, Qualified Opportunity Zones (QOZ) came into existence with significant tax incentives available for investments in low-income communities. This article provides a brief summary of the tax benefits available to Opportunity Zone investments and what types of investments will qualify.
What are the Opportunity Zone tax incentives?
There are three main tax benefits associated with Qualified Opportunity Zone investments – gain deferral, gain reduction, and gain exclusion.
Taxpayers realizing capital gains from sales or exchanges of property (real estate, investment property, securities, etc.) can defer recognition of those gains by reinvesting in a Qualified Opportunity Zone within 180 days. By doing so, the initial gain will not be recognized until the earlier of 1) disposition of the QOZ investment or 2) December 31, 2026, (mandatory recognition date). In exchange for deferral, the taxpayer’s initial basis in the QOZ investment is reduced by the deferred gain.
The mandatory December 31, 2026, recognition date is important. If the taxpayer still holds a Qualified Opportunity Zone investment on that date, they will immediately recognize the lesser of 1) the initial deferred gain or 2) the current fair market value (as determined by an appropriate valuation) of the QOZ investment. The lesser of these two figures is then reduced by the taxpayer’s basis (which will have increased up to 15 percent of the deferred gain, if the applicable holding period has been met – see next paragraph).
As mentioned earlier, if a taxpayer defers gain through a Qualified Opportunity Zone investment their initial basis in the QOZ investment is reduced by the gain deferred. However, if the taxpayer holds the QOZ investment for five years they will receive an automatic ten percent basis increase. If they hold for two additional years, they will receive an additional five percent basis increase (percentages are of the initial deferred gain). Assuming the holding periods are met, this means that when the Qualified Opportunity Zoneinvestment is sold (or mandatorily recognized on December 31, 2026) only 85 percent of the initial deferred gain will be recognized. This results in a 15 percent permanent gain reduction.
If the taxpayer holds the Qualified Opportunity Zone investment for at least ten years, then on the date the investment is sold or exchanged, the taxpayer’s basis in the QOZ investment is automatically increased to the current fair market value (FMV). This works to completely eliminate any gains attributable to appreciation of the QOZ investment during the taxpayer’s holding period.
Qualified Opportunity Zone Investment Example
Sam Taxpayer has an investment in XYZ Corp shares that is worth $1,200,000. Sam has basis in the XYZ shares of $500,000. On July 1, 2018, Sam decides to liquidate the investment triggering a capital gain of $700,000. This gain would be recognized and taxed in 2018; however, Sam Taxpayer has identified a Qualified Opportunity Zone investment opportunity.
On December 1, 2018, Sam invests $700,000 into a QOZ investment. This is the full amount of gain that Sam would have recognized from the July sale. Because reinvestment happened within 180 days, and all of the gain was reinvested, Sam’s $700,000 gain is deferred in exchange for a basis reduction. As such, Sam’s initial basis in the Qualified Opportunity Zone investment is $0 ($700,000 investment, less $700,000 deferred gain). No gains are recognized and no tax is due in 2018.
Sam holds the QOZ investment for five years. On December 1, 2023, the first basis increase of ten percent kicks in, increasing Sam’s basis in the Qualified Opportunity Zone investment from $0 to $70,000 (10 percent of the deferred gain). Sam continues to hold the investment for two more years and receives another five percent basis increase ($35,000) on December 1, 2025. At this point, Sam’s total basis in the QOZ investment is $105,000.
Sam continues to hold the Qualified Opportunity Zone investment through 2026. On December 31, 2026, Sam is required to recognize the gain deferred from 2018. Sam recognizes capital gain of $595,000 ($700,000 initial gain, less tax basis of $105,000). Due to the basis increase from Sams five and seven-year holding period, only 85 percent of the initial gain will be recognized in 2026. Assuming a 20 percent tax rate, Sam will be subject to tax of $119,000 in 2026.
Sam continues to hold the Qualified Opportunity Zone investment until December 15, 2028, at which point Sam has held the QOZ investment for longer than ten years.On December 15, 2028, Sam secures a buyer and sells the QOZ investment at its current FMV of $1,500,000. Because of the ten-year holding period, Sam receives another basis increase up to the fair market value of the Qualified Opportunity Zone investment. This eliminates any gains attributable to the appreciation of the QOZ investment while in the hands of Sam. At sale, fair value equals Sam’s basis in the QOZ investment, and Sam is able to liquidate tax-free.
Under this scenario, Sam’s basis in the initial property (XYZ securities) was $500,000. Sam ultimately received $500,000 cash in 2018 on the XYZ sale and another $1,500,000 in 2028 on the QOZ exit. Sam’s total income was $1,500,000 (total cash received of $2 million, less initial basis in XYZ of $500,000). Sam was only required to pay taxes of $119,000 in 2026. Therefore, Sam’s effective tax rate over the life of the deal is only 7.9 percent.
What investments qualify as Opportunity Zones?
Qualified Opportunity Zone investments are made directly to a Qualified Opportunity Zone Fund. A QOZ Fund is a self-certified corporation, partnership, or LLC that holds at least 90 percent of its assets in Qualified Opportunity Zone property. QOZ property is either:
1) QOZ business property
2) stock of a QOZ corporation; or
3) an interest in a QOZ partnership.
Qualified Opportunity Zone business property is tangible trade or business property acquired by purchase after 2017 from an unrelated property. The QOZ Fund or QOZ business owned by the fund must be the original user of the property or substantially improve the property. QOZ business property must be located in a Qualified Opportunity Zone for all of the property’s holding period.
A Qualified Opportunity Zone business is a corporation or partnership which is also acquired by a QOZ Fund after 2017 (ownership must be issued solely for cash). The business must be a QOZ business at time of acquisition or must be formed to operate as a QOZ business and must qualify as a QOZ business for all of the Fund’s holding period. The Qualified Opportunity Zone business must own or lease QOZ business property subject to the same requirements above, as if the QOZ fund owned the business property directly.
There are several other requirements to be a Qualified Opportunity Zone business, most notably at least 50 percent of gross income must be earned from the active conduct of a business in a QOZ. Certain activities will prohibit the QOZ designation including operating a golf course, massage parlor, tanning salon, gambling facility, or any store whose principal business is the retail sale of alcohol to be consumed off-site (i.e. liquor stores).
Where are Richmond’s Opportunity Zones?
The Opportunity Zone neighborhoods were selected after a nomination process using 2010 census data. There are 26 designated QOZ neighborhoods around Richmond which include areas near Regency Mall, Reynolds Crossing, the Broad Street corridor from I-195 to Church Hill (including most of Scott’s Addition), Northern Church Hill, much of Manchester, the Jefferson Davis Highway corridor, Northeast Chesterfield, Eastern Henrico and Varina, the Richmond International Raceway, and sections of the tri-cities.
The Virginia Department of Housing and Community Development has released an interactive map that shows the location of all Opportunity Zones in Virginia.
Other Qualified Opportunity Zone Considerations
For investors with gain deferral, the mandatory gain recognition on December 31, 2026, will necessitate careful planning in advance of the recognition date. Liquidity to pay the related capital gains taxes may be an issue for investors holding QOZ property, as taxes will come due whether or not the property is actually sold.
The Opportunity Zone designations statutorily expire after 2028. As of this article (July 2018), there has not been any mention as to whether the ten-year gain exclusion will apply to investments made after 2018. As the law is currently written, investors wishing to take advantage of the ten-year exclusion must make Qualified Opportunity Zone investments by December 31, 2018.
It is important to note that the Opportunity Zone program is currently a Federal tax incentive only. The gain deferral and exclusion provisions do not apply at the state level and will not serve to reduce state taxes.
While the Opportunity Zone tax benefits are powerful and attractive, careful consideration must continue to be paid to entity formation, deal structure, future tax rates, pricing, discount rates, risk, and long-term economic outlook. The Qualified Opportunity Zone designation can and should factor into the investment decision, but only in conjunction with broader factors that will impact the feasibility of any particular deal. There are still several statutory questions related to the Opportunity Zone program, some of which have been mentioned above, and we are hopeful that IRS will be releasing additional information and guidance throughout 2018. We also anticipate guidance related to necessary filings, elections, and other compliance issues to consider in order to take full advantage of QOZ benefits.
The Opportunity Zone incentives are an attractive tax benefit available to real estate investors and developers as well as investors and proprietors of operating businesses, and will hopefully serve to transform communities that have been in need for a long time. Interested in learning more about how the incentives may apply to you? We can help. Contact your Keiter representative or our Real Estate Industry team. 804.747.0000. Email.
Read more of our related real estate tax insights:
- Opportunity Zone Funds – An Option Still Available for 2017 Tax Planning?
- Real Estate Investors and Developers: Are You Aware of the Historic Rehabilitation Tax Credit?
- How to Use 1031 Exchange Funds to Improve Acquired Property
- Important tax developments that may affect you, your investments, and your livelihood
- Keiter Blog
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.