Article written by:
Darci Congrove, CPA
Since the Federal Opportunity Zone tax incentive program was written into law at the end of 2017, state and local governments have designated more than 8,700 economically depressed regions across all 50 states as qualified opportunity zones. When taxpayers direct their capital gains into these designated zones, they are rewarded with the opportunity to defer – or even eliminate a portion of – their capital gains tax.
Since the Tax Cuts and Jobs Act wrote this incentive into law, the Treasury Department has released two sets of proposed regulations that clarify how the program will work. The first was published in October 2018, and the second in April 2019. But even with the additional guidance, taxpayers are cautious about taking the first step. To help, we would like to break down some common misconceptions about the law so that taxpayers feel confident that their investments will qualify for preferential tax treatment.
If taxpayers keep their investment in an Opportunity Zone long enough, all capital gains taxes will be forgiven.
This statement is misleading. The original capital gain that was transferred into the opportunity fund can never be permanently excluded from taxable income. It can, however, receive a step-up in basis so that the taxpayer pays less tax on their initial investment. Thanks to the step-up in basis, a taxpayer who holds his/her investment in an opportunity fund for five years will pay tax on only 90% of the original gain. At seven years, they will pay tax on only 85% of the original gain.
The only capital gains that can be permanently excluded from taxable income are those that accrue within the fund itself (i.e. appreciation). Gains resulting from appreciation of a QOF investment will be excluded from taxable income only if the taxpayer holds their investment in the opportunity zone for ten or more years.
Once an opportunity fund vests in qualified opportunity fund assets, the fund cannot divest those assets for 10 years.
This statement is false. Opportunity Funds can divest an asset during the 10-year window, but only if they reinvest those proceeds into another qualifying asset. Just like their initial investment, they are given 180 days to reinvest into a replacement asset to continue the tax deferral. However, the interim gains recognized on any assets sold by the fund prior to the 10-year mark will be recognized taxable gains that flow to the investors in the fund.
The 180-day period for investment always begins on the date of sale.
Again, this statement is false. The Regulations state that the window begins on the day the gain would have been recognized had it not been deferred. For capital gains, the clock would start ticking on the date the taxpayer sold their asset, but the conclusion is different for Section 1231 gains. The treatment of Section 1231 gains is determined at the end of the year; some will be capital, and some will be ordinary. Therefore, the 180-day period for Section 1231 gains begins on December 31. Gains that are reported on a K-1 via an investment in a partnership or S-corp are also deemed to have occurred on the last day of the entity’s tax year, which is generally December 31.
Taxpayers can use the money they saved on tax deferral to invest in other opportunities.
As always, taxpayers are free to use their money as they wish, but they should remember to plan for liquidity to cover the deferred tax bill. At its heart, the Qualified Opportunity Zone tax incentive is a tax deferral, not an exclusion. The moment taxpayers pull their investment from an opportunity fund, they will owe capital gains tax on the deferred gain. If they hold their investment for less than five years, they must pay tax on 100% of their deferred gain. If they divest after five years, they will owe 90%, and after seven years, 85%. And all taxpayers, no matter what, will owe taxes on their initial investment in the year 2026, which is the end of the deferral period.
Investors of all types can make an opportunity zone investment. It’s not necessary to have real estate experience to reap the benefit of this tax saving program. If you have questions about opportunity zones or need assistance with making a qualified investment, GBQ can help! For additional information call us at (614) 221-1120 or click here to contact us.