Opportunity Zones Present Ability to Defer Capital Gains

Prior to the 2017 tax reform bill, investors were able to utilize a popular tax-deferral strategy known as a 1031 exchange to defer capital gains on like-kind exchanges -- essentially disposing of one asset and acquiring another replacement asset to avoid generating a current tax liability from the sale of the first asset. Tax reform provided yet another strategy: investment in Qualified Opportunity Zones. Investors seeking preferential tax treatment of capital gains would be wise to consider investment into these economically-distressed communities.

How it works

Subject to the requirements below, a taxpayer can defer immediate recognition of the gain, and, depending on the holding period, get a reduction in the amount of gain realized through a basis adjustment and possibly eliminate tax on the realized appreciation in the value of the interest/assets held in a “Qualified Opportunity Fund.”

A Qualified Opportunity Zone is an economically distressed community that has been designated as a “qualified opportunity zone.” A list of qualified zones can be found here.

The steps and requirements are as follows:

1. The investment of gain must be made in a “Qualified Opportunity Fund” within 180 days of the date of the sale or exchange that generated the gain. This fund should be structured as either a partnership or a corporation set up for the purpose of investing in qualified opportunity zone property. Note that the taxpayer will need to self-certify that it is a Qualified Opportunity Fund. To date, IRS has not released an official form for doing this, so consulting with a tax expert at this step is critical.
2. The Qualified Opportunity Zone Fund then makes an investment in a Qualified Opportunity Zone business that holds at least 90% of its assets in a Qualified Opportunity Zone.
3. The taxpayer must hold an interest in the Qualified Opportunity Zone Fund for at least five years to receive an increase in basis in the investment equal to 10% of the deferred gain invested in the Fund. Holding for seven years increases basis by an additional 5% of the deferred gain invested in the Fund. Note that if the investment is held for seven or more years then only 85% of the initial gain will be subject to capital gains tax. The period of capital gain tax deferral ends on the earlier of the date the investment is sold or December 31, 2026. If the investment is held longer than 10 years, the taxpayer will get a step up in basis in the interest in the Fund equal to the then fair market value.

Conclusion

Investment in Opportunity Zones provide significant planning opportunities for many investors and has the potential to generate additional long-term investment in areas most deserving. It may be a useful tool in capital gains deferral, particularly for individuals, funds, and companies considering investments in low-income communities, and could be ideal for private-equity funds and real estate developers for raising equity. At the very least, this new incentive program provides a capital gains deferral mechanism for short-term investments in a form that is more attractive than current Sec. 1031 like-kind exchanges. 

The numerous requirements and technicalities to utilizing the Opportunity Zone tax deferral, as well as the factors involved in deciding where to invest, mean you shouldn’t make this decision alone. An advisory firm steeped in real estate investment strategy and tax savings strategies is your best bet. We're happy to help you get started.