Tax Reform's New Incentives for Investments in Low-Income Communities: Part 3
Key Benefits for Investing Taxpayers and a Review of Recent Developments
Please note: This alert was updated as of Oct. 24, 2018.
- Part 1 and Part 2 of this series of Holland & Knight alerts described the new tax incentive contained in the Tax Cuts and Jobs Act for investments in low-income communities designated as "Opportunity Zones."
- In Part 3, we discuss the benefits for investing taxpayers, namely the deferral or partial exclusion of gain from the sale or exchange of an asset by a taxpayer who invests in a Qualified Opportunity Fund, as well as the potential exclusion of gain from disposition of an investment in a Qualified Opportunity Fund.
Part 1 and Part 2 of this series of Holland & Knight alerts described the new tax incentive contained in the Tax Cuts and Jobs Act (the Act) for investments in low-income communities designated as "Opportunity Zones." The Opportunity Zone incentive and related rules are now codified in Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code.
- Part 1 of this series set forth the process for nomination by state governors and designation of Opportunity Zones by the U.S. Department of the Treasury.
- Part 2 focused on the requirements for formation and certification of a Qualified Opportunity Fund and the rules governing its operations.
In this third alert in the series (Part 3), we discuss the benefits for investing taxpayers, namely the deferral or partial exclusion of gain from the sale or exchange of an asset by a taxpayer who invests in a Qualified Opportunity Fund1, as well as the potential exclusion of gain from disposition of an investment in a Qualified Opportunity Fund.
Deferral of Gain from Sale or Exchange of Property to the Extent of Investment in Qualified Opportunity Fund
Pursuant to Section 1400Z-2, a taxpayer who would recognize capital gain from the sale to, or exchange with, an unrelated person2 of any property held by the taxpayer may elect3 to defer recognition of the gain to the extent of the aggregate amount invested in a Qualified Opportunity Fund during the 180-day period beginning on the date of the sale or exchange.
No election to defer gain can be made 1) after Dec. 31, 2026, or 2) if an election previously made with respect to such sale or exchange is in effect. The latter rule may affect installment sales, and an investment in a Qualified Opportunity Fund equal to less than all of the potential gain from a sale or exchange of property followed by a further investment in a Qualified Opportunity Fund.
Except for a potential partial exclusion described below, the deferred capital gain (Deferred Capital Gain) is included in the taxpayer's gross income on the earlier of 1) the date on which the Qualified Opportunity Fund investment is sold or exchanged, or 2) Dec. 31, 2026 (the Recognition Date).
The amount of gain included in gross income on the Recognition Date is equal to the excess of A) the lesser of 1) the Deferred Capital Gain or 2) the fair market value of the Qualified Opportunity Fund investment over B) the taxpayer's basis in the Qualified Opportunity Fund investment. Except for the adjustments arising from the step-up in basis after certain holding periods described below, the taxpayer's basis in the Qualified Opportunity Fund investment is generally deemed to be zero.4 For example, if the Deferred Capital Gain is $100 and the fair market value of the Qualified Opportunity Fund investment declines from $100 to $80 on the Recognition Date, the amount required to be included in income on that date would be the lesser of the two amounts (i.e., $80, not $100). Special rules provided in the Proposed Regulations allow the taxpayer to dispose of their interest in a Qualified Opportunity Fund and reinvest in a different Qualified Opportunity Fund.
Because of the zero basis rule, it appears that a taxpayer may be unlikely to recognize a loss on the sale of the Opportunity Fund Investment unless it holds the investment long enough to qualify for the basis increase in years five and seven described in the next section. Moreover, the zero basis rule will affect the tax attributes of the Qualified Opportunity Fund investment during its holding period. For example, if a Qualified Opportunity Fund is a partnership operating a trade or business that owns tangible property, it appears that depreciation deductions allocated to the partner that owns an interest in the Qualified Opportunity Fund would not be recognized because it would have no basis in its interest in the Qualified Opportunity Fund.5 It is unclear whether liabilities would increase the basis of a Qualified Opportunity Fund investment if the Qualified Opportunity Fund were a partnership.
Partial Step-Up in Basis of Opportunity Zone Investment if Holding Period Equals or Exceeds Five Years
Notwithstanding the zero basis starting point, if the Opportunity Zone investment is held for at least five years, the basis of such investment is increased by an amount equal to 10 percent of the Deferred Capital Gain. If the Opportunity Zone investment is held for at least seven years, the basis in the investment is increased by an additional 5 percent of the Deferred Capital Gain. If the investment has not been sold by Dec. 31, 2026, the remaining 85 percent of the Deferred Capital Gain must be recognized and, due to the partial step up and gain recognition on the Recognition Date, the basis of the investment is correspondingly increased to 100 percent of the Deferred Capital Gain. The Proposed Regulations make clear that the character of the gain recognized is the same as it would have been if the Deferred Capital Gain was recognized at the time of the original sale or exchange.
If the property is held for more than seven years, the above provisions result in an exclusion from income of an aggregate of 15 percent of the Deferred Capital Gain and a deferral of the remaining 85 percent of the Deferred Capital Gain until Dec. 31, 2026 (unless sold earlier), when 85 percent of the Deferred Capital Gain must be recognized.
Election to Exclude Gain on Opportunity Fund Investment Held at Least 10 Years
If the Qualified Opportunity Fund investment is held for at least 10 years, a second election6 may be made to increase the basis of the Qualified Opportunity Fund investment to the fair market value of the investment on the date it is sold or exchanged.7 This will have the effect of excluding from gross income any gain on the Qualified Opportunity Fund investment in excess of the amount of any Deferred Capital Gain recognized on Dec. 31, 2026. Because the Recognition Date for Deferred Capital Gain is set before the expiration of 10 years from the earliest possible Qualified Opportunity Fund investment, Deferred Capital Gain can never be fully excluded from income. Importantly, the Proposed Regulations make clear that a taxpayer can make this election as late as Dec. 31, 2047, even after the Opportunity Zone designation has expired.
Example: Assume that a taxpayer sells stock on Aug. 1, 2018, at a taxable gain of $1 million. She would owe $238,000 in tax on the gain for the 2018 tax year. However, if she invests $1 million in an Opportunity Fund in 2018, makes the applicable deferral election and holds the investment until Dec. 31, 2026, she would pay tax on $850,000 of taxable gain (85 percent of $1 million) or $202,300 for the year 2026.811 In addition, if she holds the Qualified Opportunity Zone investment for 10 years (in this case, 2028) and makes the applicable second election, then sells it for $2 million, the basis in the investment would be increased to $2 million and there would be no tax on the $1 million of post-deferral gain.
In this scenario, the taxpayer enjoys all of the taxpayer-favorable rules discussed above: the deferral of gain, the partial step-up in basis and the second election to exclude gain.
Investments with Mixed Funds
Section 1400Z-2(e) states that in the case of an Opportunity Fund investment, only a portion of which consists of investments of gain to which an election under Section 1400Z-2 (a) is in effect, the investment will be treated as two separate investments. One investment will include only the amounts to which a deferral election under subsection (a) applies (the "Deferred Gain investment"), and any amounts to which an election does not apply will be treated as a separate investment. The deferral, recognition and gain exclusion provisions of Section 1400Z-2(a), (b) and (c) will only apply to the Deferred Capital Gain investment. The separate treatment suggests that, in the case of a Qualified Opportunity Fund structured as a partnership, any partnership liabilities will be allocated to the separate investment and not to the Opportunity Fund investment.
Conclusion and Considerations
The Opportunity Zone tax incentive is a powerful one. Investors who have capital gains should consider investing in a Qualified Opportunity Fund. While recent guidance by the U.S. Department of Treasury and the IRS is very helpful to investors, some questions remain. (See Holland & Knight's alert, "New Guidance on Opportunity Zones: Incentives for Investments in Low-Income Communities," Oct. 22, 2018.)
1 A qualified Opportunity Fund is defined in Section 1400Z-2(d)(1) as any investment vehicle organized for the purpose of investing in a Qualified Opportunity Fund and that holds at least 90 percent of its assets in "qualified opportunity zone property." Part 2 of this alert series describes in detail the requirements for formation, certification and operation of a Qualified Opportunity Fund.
2 For purposes of Section 1400Z-2, persons are related to each other if such persons are described in Section 267(b) or Section 707(b)(1), but substituting "20 percent" for "50 percent" in each such place it occurs in such sections.
3 Guidance about how and when to make this election will need to be developed by the U.S. Department of the Treasury.
4 Because the taxpayer's basis in the Opportunity Fund investment is deemed to be zero, it appears that the taxpayer's starting capital account would also be zero, assuming the rule applies for all purposes.
5 The result would be different if the Qualified Opportunity Fund is structured as a corporation that does not pass through tax items to its owners.
6 Guidance about how and when the two elections must be made will need to be developed. Because this is a separate election from the election to defer gain, it should not be affected by the rule that no election to defer gain can be made if an election previously made is in effect.
7 Because the Recognition Date for Deferred Capital Gain in less than 10 years away, only appreciation on the Opportunity Zone investment itself (as opposed to the Deferred Gain on the previous investment) will be impacted by this election.
8 The taxpayer's basis would have been stepped up by 10 percent of the deferred gain in Year 5 and an additional 5 percent of the deferred gain in Year 7, resulting in tax on 85 percent of the deferred gain.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.