Editor: Marcy Lantz, CPA
Congress for many years has looked for ways to increase investment in underdeveloped communities across the United States. So, it was not surprising that in December 2017, when the tax reform law known as the Tax Cuts and Jobs Act, P.L. 115-97, was passed, it contained a provision providing tax advantages to taxpayers who invest in underdeveloped areas. Notably, this version of tax incentives was different from prior attempts, such as qualified empowerment zones and new markets credits, because the initial tax benefit is for an unrelated tax gain and occurs when the investment is made.
Sec. 1400Z-2 offers three ways for a taxpayer to benefit financially from investing directly or via a passthrough entity in a qualified opportunity zone (QOZ). This discussion highlights those advantages and does not address all the intricacies or mechanics of the law or the two sets of proposed regulations that have been released, many of which are covered in Tax Adviser articles in the May 2019 and August 2019 issues (see Nitti, "Opportunities Beckon in New Qualified Opportunity Zones," The Tax Adviser (May 2019), and Nitti, "IRS Provides Clarity in Second Round of Opportunity Zone Regulations," The Tax Adviser (August 2019).
The first tax advantage Sec. 1400Z-2 provides is deferral for any gain from a sale or exchange (excluding related-party gain) treated as a capital gain that is invested in a qualified opportunity fund within 180 days after the sale or exchange. The gain is deferred until the earlier of the date on which such investment is sold or exchanged or Dec. 31, 2026, at which point the lesser of the deferred gain or the fair market value (FMV) of the property less the basis in the investment is included in income. Assuming tax rates do not increase, this gain deferral provides the financial benefit related to the time value of money, since the taxes on the gain being deferred are not due until some future date, either when the investment is sold or exchanged or when the deemed gain recognition happens on Dec. 31, 2026.
The second tax advantage Sec. 1400Z-2 provides is two increases in the basis of the investment for taxpayers that hold their QOZ investment for the required periods, which effectively exclude from tax up to 15% of the original gain deferred. The first benefit occurs after holding the investment for five years, when the basis in the investment is increased by 10% of the original gain deferred, and the second is after seven years, when the basis of the investment is increased by another 5% of the original gain deferred.
To take advantage of the seven-year basis increase provision, the taxpayer must make the QOZ investment by Dec. 31, 2019. This date is required because of the deemed recognition date of Dec. 31, 2026, for inclusion of the deferred gain. Likewise, for the five-year provision, the investment must be made by Dec. 31, 2021. To receive the maximum benefit from these tax savings opportunities, the tax rate on capital gains will need to be equal to or lower than the current capital gains rate, depending on the taxpayer. An increase in the tax rate could be partially or fully offset by the exclusion of 10% or 15% of the gain and by investment earnings on the deferred tax, but there is a risk that rising tax rates could reduce or eliminate the deferral's tax savings.
The third tax advantage of Sec. 1400Z-2 has the potential to be a substantially greater benefit than the gain deferral and partial exclusions. If the taxpayer is willing to hold the QOZ investment for 10 years and sells or exchanges the investment before Jan. 1, 2048, the taxpayer can elect to increase the basis of the investment to its FMV on the date it is sold or exchanged, so there is no gain or loss on the sale of the investment. This complete exclusion from tax of all the post-investment appreciation could save a significant amount of tax on a successful investment.
The following example illustrates the potential tax savings:
Example: A recognizes a capital gain of $100,000 in January 2018, and 100% of the gain is invested in a QOZ investment within 180 days of the gain recognition. Aholds the investment until Dec. 31, 2028, at which time A sells the investment for $250,000. A is not subject to the net investment income tax in 2018 or 2028, and the capital gains tax rate of 15% applies.
A does not owe any tax in 2018 on the $100,000 capital gain. Since A held the investment for longer than seven years, in January 2027 when the fourth-quarter estimated tax for 2026 is due, A will owe $11,475 (90% of $12,750 ($100,000 × 85% × 15%)) and the remaining $1,275 in April 2027. A has saved $2,250 in taxes and accumulated the after-tax return on investment (ROI) from the $15,000 tax deferred for almost nine years. Finally, in 2029, when the taxes are due for the sale of the investment in December 2028, A will pay zero taxes instead of the $22,500 that would have been owed on the $150,000 gain taxed at 15%.
The ROI of the QOZ will ultimately determine the amount of tax benefit a taxpayer receives. Since the determination of whether an area was eligible to be a QOZ was based upon 2010 Census data, some of the areas were already experiencing gentrification before being designated as a QOZ in 2018. In these areas, particularly, investing as soon as possible will increase the chances for the greatest tax benefits.
For partners in partnerships that are eligible to defer gain on a sale or exchange but that do not defer gain, the 180-day period with respect to the partner's eligible gains in the partner's distributive share generally begins on the last day of the partnership tax year. However, these partners can elect to treat their own 180-day period with respect to their distributive share of the partnership's gains as being the same as the partnership's 180-day period beginning on the date of sale, instead of waiting for the 180-day period beginning on the last day of the partnership tax year. Unfortunately, for Sec. 1231 gains recognized in 2019, the taxpayer must wait for the 180-day period to begin on Dec. 31, 2019, before investing in the QOZ.
When a taxpayer chooses to invest in a QOZ, the potential exists for the taxpayer to make a positive impact on an underdeveloped community and increase the taxpayer's ROI through tax savings. This is the potential win-win that Congress envisioned when creating the incentive.
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica Inc.</