Eliminating Capital Gain Tax – Qualified Opportunity Zones

Overview

The Tax Cuts and Jobs Act (TCJA) added a new section to the Internal Revenue Code (Code) to provide temporary deferral from gross income of capital gains incurred on the sale or exchange of an investment in a Qualified Opportunity Fund.  I.R.C. §1400Z-2, as added by TCJA §13823.  A Qualified opportunity fund is part of an “Opportunity Zone” - essentially an economically distressed area where long-term investments by a taxpayer in a Qualified Opportunity Fund are incentivized by the deferral of capital gain taxes.  It is not necessary that the investor actually live in the opportunity zone.  It’s only required that the taxpayer invest in a Qualified Opportunity Fund.   

Farmers and ranchers can qualify to take their capital gains and invest them in a Qualified Opportunity Fund (an investment vehicle that is organized as a corporation or a partnership that holds at least 90 percent of its assets in Qualified Opportunity Zone property) that, in turn, invests in a Qualified Opportunity Zone property  So, this new TCJA provision could be of particular interest to farmers and ranchers that have large gains that they are looking to defer capital gain taxes on.

The tax implications of Qualified Opportunity Zone investments – that’s the topic of today’s post.

Technical Details

As noted, I.R.C. §1400Z-2 provides for the temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the Qualified Opportunity Fund. I.R.C. §1400Z-2.  The fund must be located in a Qualified Opportunity Zone, which is a “designated low-income community population census tract.”  The number of designated tracts in any particular State cannot exceed 25 percent of the number of population census tracts in that State that are “low income communities.”  A Qualified Opportunity Zone remains in effect for ten calendar years after the date of the designation.  I.R.C. §1400Z-1.   

A taxpayer that incurs a capital gain but who reinvests it in a Qualified Opportunity Fund that is located in a Qualified Opportunity Zone obtains temporary deferral of that gain (both short-term or long-term).  The maximum amount of the deferred gain equals the amount invested in the Qualified Opportunity Fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains.  Excess capital gains are included in the taxpayer’s gross income.  The unrealized gain can then be realized on a tax-deferred basis until at least December 31, 2026.  In addition, the taxpayer receives a 10 percent stepped-up basis on the deferred capital gains (10 percent of the amount of the deferred gain) if the investment in the Qualified Investment Fund are held for at least five years, and 15 percent if it is held for at least seven years.  Once the investment has been held for 10 years, the tax on the gain is eliminated. 

The deferred gain can be elected to be permanently excluded upon the sale or exchange of the investment in a Qualified Opportunity Fund that the taxpayer has held for at least 10 years.  What the election does is cause the taxpayer’s income tax basis in the investment to be the fair market value of the investment as of the date of the sale or exchange.  In addition, any loss on the investment can be recognized.  I.R.C. §1400Z-2.

In Revenue Procedure 2018-16, the IRS announced the designation of Qualified Opportunity Zones in 18 states.  In addition, a safe harbor was provided for applying the 25 percent limitation to the number of population census tracts in a State that can be designated as a Qualified Opportunity Zone.  Rev. Proc. 2018-16, I.R.B. 2018-9.  The IRS noted that a State Governor can nominate a census tract for designation as a Qualified Opportunity Zone by notifying the IRS in writing of the nomination.  The IRS then will certify the nomination and designate the tract as a Qualified Opportunity Zone beyond the end of the “consideration period.”  I.R.C. §1400Z-1(b). 

Earlier this year, the IRS approved submissions for areas in Arizona, California, Colorado, Georgia, Idaho, Kentucky, Michigan, Mississippi, Nebraska, New Jersey, Oklahoma, South Carolina, South Dakota, Vermont and Wisconsin. 

In Notice 2018-48, the IRS listed all of the designated Qualified Opportunity Zones.  Presently, every state has submitted to the Treasury Department its list of proposed Opportunity Zones. Notice 2018-48, I.R.B. 2018-28.

What About I.R.C. §1031?

The TCJA eliminated (on a permanent basis) the tax-deferred exchange provision under I.R.C. §1031 for exchanges of personal property.  Real estate exchanges remain eligible for I.R.C. §1031 treatment.  So, how does this new TCJA provision compare with I.R.C. §1031? 

• Unlike a real estate trade under I.R.C. §1031, a taxpayer’s investment in a Qualified Opportunity Fund only requires that the capital gains portion from the sale of property be reinvested. An I.R.C. §1031 transaction requires that the entire sale proceeds be reinvested. 
• In addition, the investment in a Qualified Opportunity Fund does not have to involve like-kind property, and the investment property can be real or personal.
• The replacement property need not be identified (as it does in an I.R.C. §1031 transaction).
• The 180-day rule applies in both situations. In other words, the closing on the “replacement property” must occur within 180 days with respect to a Qualified Opportunity Zone as well as with respect to an I.R.C. §1031 exchange.
• Also, with respect to an investment in a Qualified Opportunity Zone, a partnership interest is allowed. That’s not the case with an I.R.C. §1031 exchange.  The same can be said for stock in a corporation. 
• The gain is deferred permanently (excluded from income) if the property is held in a Qualified Opportunity Fund for at least 10 years. With an I.R.C. §1031 exchange, the gain is deferred until the replacement property is sold, unless the gain is deferred in another like-kind exchange (or the taxpayer dies). 
• With an investment in a Qualified Opportunity Zone, the sale of the invested property cannot be to a related party. Related party sales are not barred for like-kind exchange property where gain is deferred under I.R.C. §1031, but a two-year rule applies – the property must be held for at least two years after the exchange if a related party is involved. 

Example

Assume that Bob owns Blackacre that with a current fair market value of $1,000,000.  Bob’s income tax basis in Blackacre is $500,000.  Bob sold Blackacre for $1,000,000 on October 1, 2018, resulting in a realized gain of $500,000.  Bob has until March 1, 2019 (180 days after the sale date) to invest the sale proceeds in a Qualified Opportunity Fund equal to the amount of gain that he elects to defer.  

Now assume that Bob elects to defer the full amount of the realized gain and invests the $500,000 in a Qualified Opportunity Fund in a timely manner.  Further assume that Bob sells his investment in the Fund on March 1, 2024, for $600,000.  Bob could exclude the lesser of the amount of gain previously excluded ($500,000) or $600,000 (the fair market value of the investment on the sale date).  From that $500,000 amount is subtracted Bob’s basis in the Fund investment (initial basis in Fund investment ($0), increased by the amount of the original gain previously recognized ($0)).  Thus, Bob’s basis in the Fund’s investment is zero. 

Note:  Because Bob held the investment for at least five years, his basis is increased by 10 percent of the deferred gain or $50,000 ($500,000 x .10).  Had Bob held the investment for at least seven years, he would have qualified for an additional five percent basis adjustment. 

Bob’s recognized gain in 2024 associated with the prior deferral would be $450,000 ($500,000 less the $50,000).  In 2024, Bob would also recognize a $100,000 gain associated with the sale of his Fund investment.  Thus, Bob’s total recognized gain in 2024 is $550,000.  If Bob were to hold the investment in the Fund for at least 10 years, he could exclude all of the gain associated with the investment.  However, the 10-year holding period has no impact on the taxability of Bob’s original deferred gain.  That gain cannot be deferred beyond 2026. 

Conclusion

The Opportunity Zone provision of the TCJA is particularly tailored to a taxpayer that has an asset (or assets) with inherent large built-in gain.  In other words, the provision may be particularly attractive to a taxpayer with a low income tax basis in the property and the property has appreciated greatly in value.  There is a great deal of farm and ranch land that falls into that category. In addition, many opportunity zones are located in rural areas and farmland and timberland investments tend to be long-term.  It’s these long-term investments that can be a prime candidate for using this new tax provision.