With the real estate and stock markets heating up, it is not unusual to encounter clients that have significant capital gains and are looking for ways to reduce their tax burden. The recently enacted law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, created an incentive program that allows a taxpayer to elect to exclude from gross income capital gain if it is properly reinvested in a qualified opportunity zone (QOZ) through a qualified opportunity fund (QOF) within 180 days of the sale (Sec. 1400Z-2(a)(1)). The gain is then deferred until the earlier of the date in which the investment in the QOF is sold or Dec. 31, 2026 (Sec. 1400Z-2(a)(2)).
A QOF is any investment vehicle that is organized as a corporation or a partnership for the purpose of investing in QOZ property (other than another QOF) that holds at least 90% of its assets in QOZ property. QOZ property includes investments in QOZ stock, QOZ partnership interest, and QOZ business property. The definitions of QOZ stock, QOZ partnership interest, and QOZ business property encompass investments in new or substantially improved tangible property, including commercial buildings, equipment, and multifamily complexes, with a common requirement that such investments must be made in QOZs.
Gain the taxpayer elects to defer is included in income at the earlier of when the investment is sold or exchanged or Dec. 31, 2026. This gain will be the excess of: the lesser of (1) the amount of gain excluded, or (2) the fair market value (FMV) of the investment in the QOF; over the taxpayer's basis in the investment (Sec. 1400Z-2(b)(2)(A)).
The initial basis in a QOF investment is zero. If the investment is maintained in the QOF for five years, the taxpayer receives a step-up in basis equal to 10% of the original gain (i.e., only 90% of the deferred gain is then recognized if the fund is sold) (Sec. 1400Z-2(b)(2)(B)(iii)). If the investment is maintained in the QOF for seven years, the taxpayer receives a step-up in basis equal to an additional 5% (or a combined total of 15%) of the original gain (i.e., only 85% of the deferred gain is then recognized if the fund is sold) (Sec. 1400Z-2(b)(2)(B)(iv)).
The following two examples from the TCJA illustrate these tax benefits:
Example 1: On Jan. 2, 2018, ABC Corp. sells property to an unrelated party and has a resulting gain of $1 million, which ABC Corp. then reinvests in InvestFund, a QOF, on March 31, 2018. ABC Corp. sells its investment in InvestFund on April 2, 2021, for $1.5 million. Since ABC Corp. held its investment in InvestFund for less than five years, its basis in the investment is $0. In its 2021 tax year, ABC Corp. must recognize the deferred gain of $1 million as well as the $500,000 in appreciation.
Example 2: Assume the same facts as Example 1, except that ABC Corp. sells the investment in 2025. Since the investment is held for more than seven years, ABC Corp.'s basis increases from $0 to $150,000, thus reducing the amount of deferred gain it must include to $850,000 ($1,000,000 - $150,000). The additional $500,000 in appreciation must also be recognized.
Finally, if the taxpayer holds the QOF investment for at least 10 years, the taxpayer can elect to increase the basis of the property to its FMV on the date that it is sold or exchanged (Sec. 1400Z-2(c)). In this case, any appreciation of the QOF investment above the taxpayer's initial investment of gain will not be subject to tax.
QOFs will self-certify by completing a not-yet-released IRS form and attaching it to their federal income tax return; no IRS approval is required. A taxpayer makes the election to defer gain invested in a QOF on the return on which the tax on that gain would be due if the taxpayer did not defer it.
This new incentive program will provide significant planning opportunities for many investors and is intended to generate additional long-term investment in areas most deserving. This program has garnered little attention and may be a useful tool in capital gains deferral, particularly for individuals, funds, and companies considering investments in low-income communities. It could be ideal for private-equity funds and real estate developers for raising equity. At worst, 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.
Michael D. Koppel, CPA (Retired)/PFS/CITP, is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.