While some may debate which provisions in the recently passed Tax Cuts and Jobs Act (TCJA) are to the benefit of the taxpayer and which provisions are to their detriment, one of the provisions that could serve as a hidden gem is the creation of Qualified Opportunity Zones (QO Zones) for certain low-income population areas. Similar to some programs created in the past, the purpose of a QO Zone is to encourage economic growth and investment in distressed and low-income communities by providing federal tax benefits.
The governor of each state has until March 22, 2018, to nominate an area, or a tract, for designation as a QO Zone and then must submit a limited number of nominations to the IRS in writing. The IRS has 30 days from receiving the nominations to certify them.
To qualify for designation as a QO Zone, the area must be a population census tract that is a low-income community as defined in Internal Revenue Code Section 45D(e). Section 45D(e) looks to the poverty rate of the tract (must be at least 20%) and also to the median family income of the area (there are differing requirements based upon whether the tract is located in a metropolitan or a rural area).
A population tract that is not a low-income community itself can still be designated as a QO Zone if the tract is contiguous with a low-income community that is designated as a QO Zone, and the median family income of the tract doesn’t exceed 125% of the median family income of the contiguous low-income community.
Once made, a designation as a QO Zone remains in effect for the period beginning on the date of the designation and ending at the close of the tenth calendar year beginning on or after the date of designation.
The creation and deployment of funds into a QO Zone will provide taxpayers with two main tax incentives.
Temporary Deferral of Inclusion of Gain
The first incentive is a temporary deferral of the inclusion in gross income for the gains from a sale or exchange with an unrelated party that are reinvested in a qualified opportunity fund (QO Fund) after December 31, 2017. A QO Fund is an investment vehicle that is organized as a corporation or partnership that invests in QO Zone property.
QO Zone property falls into three different categories, all of which must have been acquired by the QO Fund after December 31, 2017:
- The original issue stock of a QO Zone business,
- A partnership interest in a QO Zone business or
- Tangible property used in a QO Zone business whose original use of such property in the Zone commences with the QO Fund, or for which the QO Fund is considered to have substantially improved.
Note the investment in QO Zone property must be made directly by the QO Fund and can’t be made by investing through another QO Fund or other entity. The taxpayer will be required to include the deferred gain into income on the date on which the investment is sold or exchanged, or on December 31, 2026 — whichever is earlier.
For purposes of determining the gain that will be included on that date, the taxpayer’s basis in his initial investment in the QO Fund will be considered zero. To encourage long-term investment, the longer the taxpayer holds the investment, the more his basis in the investment is increased.
If the investment in the QO Fund is held for less than five years, the taxpayer’s basis will be zero and 100% of the gain that was temporarily excluded will be required to be included into income, in addition to any appreciation on the investment in the QO Fund.
If the investment in the QO Fund is held for at least five to seven years prior to December 31, 2026, the taxpayer will be entitled to increase his basis by 10% of the gain that was originally deferred. As a result, only 90% of the gain that was temporarily excluded will be required to be included into income, in addition to any appreciation on the investment in the QO Fund. If the investment in the QO Fund is held for at least seven years prior to December 31, 2026, but less than 10 years, the taxpayer will be entitled to increase his basis by 15% of the gain that was originally deferred. As a result, only 85% of the gain that was temporarily excluded will be required to be included into income, in addition to any appreciation on the investment in the QO Fund.
Permanent Exclusion of Post-Acquisition Gain
The second benefit is the opportunity to permanently exclude the appreciation on the original investment in the QO Fund. To be eligible to exclude the post-acquisition gain (otherwise known as the appreciation on the investment), the taxpayer must retain their investment in the QO Fund for at least 10 years. Doing so will result in any appreciation on the QO Fund investment escaping taxation.
Example of the Benefits
A taxpayer holds Google stock and decides that she wants to sell the stock, which generates a capital gain of $1 million. Under this provision, the taxpayer has the opportunity to defer the inclusion of that capital gain into her taxable income by reinvesting the all of the proceeds into a QO Fund.
The QO Fund deploys the funds in one of the three categories of eligible QO Zone property. The taxes on the original $1 million of gain will be due either on the date the investment in the QO Fund is sold or December 31, 2026, whichever is earlier.
Year four rolls around and the investment in the QO Zone has appreciated to $1.2 million and the taxpayer decides to sell. At the time of sale, the taxes on the original $1 million invested would be due, and since the holding period is between years one and five, the taxpayer must also pay tax on the full $200,000 of appreciation.
If she instead decides to continue to hold her investment and sells it between years five and seven, she will get a 10% basis step up. Assuming that the investment in the QO Zone is sold for $1.2 million, the taxpayer will get to exclude $100,000 of the appreciation and would only be required to pay tax on $1.1 million. If the taxpayer would sell between years seven and 10, she would get another 5% in basis step up. Assuming that the investment in the QO Zone is sold for $1.2 million, the taxpayer will get to exclude $150,000 of the appreciation and would only be required to pay tax on $1.05 million.
Finally if the taxpayer can hold her investment in the QO Fund for more than 10 years and at the time of sale the investment in the QO Fund is sold for $1.5 million, the taxpayer will only be required to pay tax on 85% of the original $1 million of gain. The remaining $500,000 would escape taxation.
Opportunities to invest in QO Zones could become available as early as the end of April 2018. While each situation must be reviewed individually, the new designation of QO Zones is certainly an opportunity that taxpayers will want to explore with their tax advisors.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.