Among its many provisions, the Tax Cuts and Jobs Act of 2017 created a new tax code section: 1400Z. This section introduces Qualified Opportunity Zones (“Zone(s)”), which are designated economically distressed communities in all 50 states, the District of Columbia, and five U.S. territories that have been certified by the federal government.
Zones were created to benefit residents and businesses in those areas. In addition, investors may find opportunities for substantial gains bolstered by multiple tax incentives.
Tax deferral. Investors may defer tax on capital gains by reinvesting the amount of the gain in a Qualified Opportunity Fund (“QOF”) within 180 days of the relevant sale or exchange. The deferred gain may be derived from securities, real estate, or other capital assets; the QOF must make a qualifying investment, which might be in a private business or a real estate venture within a qualifying Zone, for example.
Only capital gains are eligible for this deferral and the subsequent investment in a QOF (“QOF Investment”) applies to equity rather than debt investments. If an acquired equity asset is encumbered by debt, the associated debt will not be eligible for the tax benefits.
Tax reduction. If before December 31, 2026, a QOF Investment is held for five years, the investor is entitled to a step-up in tax basis equal to 10% of the deferred gain (the amount invested). After an additional two years, if before December 31, 2026, another 5% step-up in basis will be credited.
Thus, a hypothetical $100,000 QOF Investment would get a $15,000 (15%) basis step-up after seven years. On the earlier of December 31, 2026, or the sale of the QOF, the deferred gain recognized would be $85,000 ($100,000 gain reduced by $15,000 basis step-up) and the basis in the QOF would be $100,000.
Tax avoidance. Yet another milestone is reached after the QOF has been held 10 years. Once the 10 year-holding period is reached, all appreciation on the QOF will be tax-free on a sale.
Continuing the above example, suppose the taxpayer made the $100,000 QOF Investment in March of 2019 and was sold or liquidated in April 2029 with the share of the taxpayer’s proceeds being $250,000.
On December 31, 2026, the taxpayer would have owed tax on the deferred gain reduced to $85,000, as explained above. Moreover, because the 10-year holding period has been met, there will be no additional tax due on the $250,000 that’s received—the $150,000 gain from the QOF Investment will be untaxed, under these new Zone rules.
As might be expected, many conditions must be met in order to receive the tax benefits for Zone investing. The IRS has described the requirements in the first set of proposed regulations (additional guidance is anticipated).
One key issue regarding the deferral of the original taxable gain is that the deferred gain, after any basis step-up, will be recognized when the QOF is sold or exchanged. However, if the QOF is still held on December 31, 2026, a mandatory recognition of gain will occur. The amount recognized will be the deferred gain or fair market value of the QOF on that date, whichever is less, over the basis in the QOF (accounting for the 10% or 15% basis step-up). In addition, the gain recognized retains the attributes it would have had if the gain was not deferred.
Thus, if the $100,000 QOF Investment in our example was long-term capital gain and is still held at the end of 2026, the remaining $85,000 gain will be recognized as long-term capital gain. Nevertheless, if that investment is valued at, say, $75,000, then the recognized gain would be the lower amount: $60,000 ($75,000 FMV less basis increase of $15,000) and taxed as long-term capital gain.
Individuals, C corporations (including RICs & REITs), partnerships, S corporations and trusts and estates are eligible to elect Section 1400Z tax deferral on IRS Form 8949, Sales and Other Distributions of Capital Assets. Regarding the 180-day deadline mentioned above, partners of a partnership that is not making the Section 1400Z election can themselves elect to defer gains on their own returns; the 180-day period for such partners to invest in a QOF starts, at the partner’s election, on either the day the 180-day period would start for the partnership or the last day of the partnership’s taxable year.
Once a QOF is established, at least 90% of its assets must be invested in qualified opportunity zone property (“Zone Investment”) that was acquired from an unrelated party after December 31, 2017 (an unrelated party for purposes of Section 1400Z is a person or persons with common ownership of 20% or less). The 90% test must be met semi-annually. A Zone Investment can be in qualified opportunity zone business property; qualified opportunity zone partnership interests; or qualified opportunity zone stock.
From the proposed regulations, it appears that the IRS has realized it may be difficult to syndicate and close proposed Zone Investments to meet the 90% requirement in a timely manner after the original QOF Investment. Thus, the IRS has begun to speculate on the timetable for a QOF to expend cash received by investors and yet avoid penalties for delays in reaching the 90% Zone Investment requirement. In the first set of proposed regulations, the IRS included a working capital safe harbor that provides some assistance in meeting this requirement. However, if such a delay might become a concern, our tax professionals at Citrin Cooperman can assist clients by providing strategic guidance.
After making the Zone Investment, the qualified property must be substantially improved by the owner if it is not originally placed in service within the Zone by the owner. To pass this test, the cost of improvements must be greater than or equal to the purchase amount. Fortunately, the proposed regulations remove the basis of property attributable to land from the calculation of the amount of money that must be spent on improvements, in order to be considered substantial.
Barring an extension or reversal by Congress, the latest gain subject to a Section 1400Z deferral would be realized on December 31, 2026, and the last 180-day reinvestment period for gain would end on July 3, 2027. The proposed regulations not only require a 10-year holding period for tax-free Zone gains, they require a sale of the Zone Investment by December 31, 2047, in order for the QOF Investment to be tax-free.
Meanwhile, the issuance of proposed regulations indicate that the IRS has begun to tackle some of the uncertainties regarding Section 1400Z. Additional regulations are likely to come from the IRS on issues such as the meaning of “substantially all,” original use requirements, and transactions that may trigger inclusion of a previously deferred gain.
For investors and developers, the economic viability of many of the projects located in the designated Opportunity Zones will be of paramount importance. That said, the multiple tax incentives should not be overlooked if the investment fundamentals are appealing.