Qualified Opportunity Zones (QOZs) provide a unique opportunity for taxpayers to invest in low-income communities while also offering significant tax benefits. QOZs were included in the 2017 Federal Tax Cuts and Jobs Act (TCJA) and are designed to encourage investment and economic growth in designated low-income communities. While QOZs offer taxpayers significant tax benefits, the provisions are complicated and require careful consideration. Keiter’s QOZ team is here to help you successfully navigate investing in QOZs.
Where are the Qualified Opportunity Zones?
Qualified opportunity zones are located in all 50 states, the District of Columbia and five U.S. territories. There are numerous QOZs in Virginia including the Shenandoah Valley, Roanoke, Farmville, and 26 neighborhoods around the Richmond area.
Tax Benefits and Timeline
There are three main tax benefits associated with Qualified Opportunity Zone investments – gain deferral, gain reduction, and gain exclusion.
Taxpayers realizing capital gains can defer recognition of those gains by reinvesting in a QOZ fund within 180 days of the sale or exchange that generated the capital gain. By doing so, the initial gain will generally not be recognized until the earlier of (1) the disposition of the QOZ fund investment or (2) December 31, 2026 (mandatory recognition date).
If a taxpayer defers gain through a QOZ fund investment, their initial basis is reduced by the gain deferred. However, if the taxpayer holds the QOZ fund investment for five years, they will receive an automatic 10% basis increase. If held for two additional years, they will receive an additional 5% basis increase (percentages are of the initial deferred gain). Assuming the holding periods are met, when the QOZ fund investment is sold (or mandatorily recognized on December 31, 2026), only 85% of the initial deferred gain will be recognized. This results in a 15% permanent gain reduction. To maximize gain reduction, qualifying investments will need to be made by December 31, 2019 (seven years prior to the 2026 mandatory gain recognition date).
If the taxpayer holds the QOZ fund investment for at least ten years, the taxpayer’s basis in the QOZ fund investment is automatically increased to the current fair market value upon sale or exchange. This works to completely eliminate any gains attributable to the appreciation of the QOZ fund investment during the taxpayer’s holding period.
While the QOZ designations statutorily expire after 2028, the second set of proposed regulations clarified that investors have until January 1, 2048 to sell their QOZ fund investments and step up their basis to fair market value. This provides investors with the opportunity to permanently avoid paying taxes on 25+ years of appreciation. It is important to note that while the QOZ program is a federal program, many states have conformed to TCJA and the QOZ program. Investors should consider the tax regulations of their home state to determine conformity with TCJA and QOZs. For states that do conform, the federal tax benefits also apply at the state level. However, for states that do not conform (e.g., North Carolina), taxpayers may be subject to state tax on the gains they intend to defer under the QOZ program. While currently only a few states have legislated new additional incentives specific to QOZs, many states and localities have existing incentive programs in the designated zones.
Tax Incentive Caveats
Given the complexities that accompany these new provisions, there are many aspects that warrant thoughtful consideration. The QOZ program only applies when investors have capital gain proceeds to reinvest; ordinary gains are not eligible for reinvestment. QOZ funds can also have cash investors who are not deferring gains; but there are no additional tax benefits for cash investors beyond what a typical investment entails. Both investors and fund operators need to be clear on all aspects of the program to ensure compliance throughout the lengthy process.
While the QOZ tax benefits are powerful and attractive, careful attention must continue to be paid to entity formation, deal structure, future tax rates, pricing, discount rates, risk, and long-term economic outlook.
Is an Opportunity Zone Incentive right for you?
Interested in learning more about how the incentives may apply to you? Our QOZ team can assist you with upfront planning to interpret regulations and plan for appropriate tax and accounting setup.