When legislators first introduced qualified opportunity zones (QOZs) to Congress, they argued that such a law would spur economic growth in distressed communities all across the United States. This provision ultimately was adopted as part of the Tax Cuts and Jobs Act in December 2017. To encourage taxpayers to invest in these “opportunity zones,” tax incentives were created for those willing to finance multi-year growth in identified communities. The incentives written into the law provide taxpayers with three potential tax benefits, which are explained below.
Temporary Deferral of Capital Gains Tax
When taxpayers sell or exchange appreciated property that they own, they have 180 days to reinvest their realized gain into a Qualified Opportunity Fund (QOF). When they do this, they avoid paying taxes on that gain in the current year and have the opportunity to defer it for up to seven years. Taxpayers will only owe taxes on that gain when they pull their investment from the QOF or at the end of the tax year 2026 – whichever is sooner. Let’s look at a brief example:
At the end of 2019, Bob sells a rental property for $750,000. His tax basis in the property at the time of sale is $500,000, which makes his realized gain $250,000. If he keeps this money, he will owe a 20% federal capital gains tax on the $250,000 gain – $50,000.
If Bob invests at least $250,000 into a QOF within 180 days of the sale, he can defer paying that $50,000 tax bill until 2026. On his 2019 tax return, his capital gains tax will be zero.
Step-Up in Basis
In addition to the temporary deferral of capital gains tax, investors in a QOF will receive a step-up in basis for their investment if they hold it long enough. If the taxpayer holds his or her investment in the QOF for at least five years, they will receive a 10% step-up in basis. If held for at least seven years, the step-up increases to 15%. Let’s see how this step-up in basis would affect Bob’s final tax bill.
Bob keeps his investment in the QOF until the end of 2024 – five years. If his investment grew 6% each year, the fair market value of his investment would be $335,000 when he sells it. Because he held his investment for at least five years, he receives a 10% step-up in basis. This means that the basis of his investment jumps from $0 to $25,000 (10% of his $250,000 investment). On his 2025 tax return, he should recognize the following tax:
| . | $45,000 | . | 90% of the capital gains tax that was deferred from his initial investment in 2020 ($250,000 – $25,000 = $225,000 x 20% capital gains tax) |
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| + | $17,000 | capital gains on the additional appreciation that occurred within the QOF ($335,000 – $250,000 = $85,000 x 20% capital gains tax) |
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| = | $62,000 | Total tax due in April 2026 with 10% step-up in basis |
Without the step-up in basis, Bob would owe the following:
| . | $50,000 | . | 100% of the capital gains tax that was deferred from his initial investment in 2020 ($250,000 – $0 basis = $250,000 x 20% capital gains tax) |
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| + | $17,000 | capital gains on the additional appreciation that occurred within the QOF ($335,000 – $250,000 = $85,000 x 20% capital gains tax) |
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| = | $67,000 | Total tax due in April 2026 without a step-up in basis |
This step-up in basis allows Bob to save $5,000 in tax over a five-year period, in addition to the time value of money benefit related to deferring the tax payment on the initial gain. If Bob were to hold the investment for seven years, he would have an additional 5% basis step-up.
Permanent Exclusion of Capital Gains Tax on Appreciation within the QOF
Taxpayers who hold their investment for at least ten years will receive the benefits of tax deferral and basis step-ups as well as a permanent exclusion from taxable income of capital gains that are attributed to appreciation within the QOF. Although the original capital gain can never be fully excluded from income, gain resulting from any subsequent appreciation will be permanently excluded if taxpayers hold the investments for at least ten years.
To understand how these incentives work together, let’s go back to our example:
Bob decided to keep his investment in the QOF until 2029 – for ten years. If his investment grew at 6% each year, the fair market value of his investment would be $448,000 when he sells it.
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- First, he would receive a temporary deferral of the capital gains tax from his initial investment until the year 2026.
- Second, because he held his investment for more than seven years, he would receive a 15% step-up in basis on his original investment. When the tax became due in April 2027, he would owe $42,500 of capital gains tax.
- Third, because he held his investment in the QOF for at least ten years, his appreciation within the QOF would be excluded from his taxable income. Therefore, in April 2030, he would not owe any capital gains taxes when selling his investment.
| . | 2019 | 2026 | 2029 | . | ||
| Bob Makes Initial Investment into QOF | Statutory End Date of Tax Deferral | Bob Sells His Investment in the QOF | ||||
| Bob defers tax on his $250,000 investment. Bob will owe no capital gains tax in April 2020. |
Bob must now pay the capital gains tax on his initial investment that he had deferred. However, because he receives a 15% step-up in basis, his tax bill is only 85% of what it would have been. He would owe $42,500 of capital gains tax in April 2027. |
Bob sells his investment. The $198,000 of appreciation that occurred in the past ten years would be excluded from Bob’s taxable income. He would owe no capital gains tax in April 2030. |
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By taking advantage of the opportunity zone provisions in the tax law you can receive 1) a tax deferral, 2) a tax reduction, and 3) a partial exclusion. Those tax savings can be directed to something else that you find important, like cash for your business or funding your child’s college tuition.
The opportunity zone rules can be confusing, and there are a number of critical deadlines that must be met in order to take full advantage of the tax savings. GBQ is here to help. If you think you want to take advantage of this tax-saving opportunity, reach out to one of our experts today. We look forward to hearing from you.
