Qualified Opportunity Zones: A Significant Tax Benefit for Investors

by Varnum LLP
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The Tax Cuts and Jobs Act, passed in December 2017, contained new Internal Revenue Code Sections 1400Z-1 and 2 aimed at developing economic growth and business in certain designated, distressed, low-income communities around the country known as Qualified Opportunity Zones. The provision provides federal tax benefits to those investors who invest in funds and businesses that target the designated Qualified Opportunity Zone boundaries.

What Are Qualified Opportunity Zones?

A specific population census tract in a state can become a Qualified Opportunity Zone if it is nominated by a state and approved by the Treasury. Each state is allowed to designate up to 25 percent of the low-income communities in the state as Qualified Opportunity Zones. The designation of a Qualified Opportunity Zone generally remains in effect for 10 years, ending on the close of the tenth calendar year beginning on or after the date of designation.

In April 2018, the IRS announced new Qualified Opportunity Zones in 18 states. Submissions were approved for:

  • American Samoa
  • Arizona
  • California
  • Colorado
  • Georgia
  • Idaho
  • Kentucky
  • Michigan
  • Mississippi
  • Nebraska
  • New Jersey
  • Oklahoma
  • Puerto Rico
  • South Carolina
  • South Dakota
  • Vermont
  • Virgin Islands
  • Wisconsin

In Michigan, Qualified Opportunity Zones include parts of:

  • Detroit
  • Grand Rapids
  • Muskegon
  • Muskegon Heights
  • Newaygo
  • Big Rapids
  • Cheboygan
  • Standish
  • Tawas City
  • Alpena
  • Lansing
  • Benton Harbor
  • Holland
  • Bois Blanc Island
  • Kalamazoo
  • Dearborn
  • Marquette

For more information on finding the designated Qualified Opportunity Zones, please visit the U.S. Department of Treasury's CDFI Fund website. The list will be updated as more Opportunity Zones are approved.

What Tax Benefits Apply to Qualified Opportunity Zones?

A taxpayer can temporarily defer taxation on certain capital gains that the taxpayer realizes in a sale or exchange of a capital asset to an unrelated party if the gain is reinvested in a Qualified Opportunity Fund. Qualified Opportunity Funds are generally investment vehicles, organized as a corporation or partnership, to invest in Qualified Opportunity Zone property (other than another qualified opportunity fund). At least 90 percent of such vehicle’s assets must be Qualified Opportunity Zone property. Qualified Opportunity Zone property includes Qualified Opportunity Zone stock, partnership interests or business property – basically, newly acquired business interests and business assets located, used and invested in the designated census tract area.

The exclusion for investing in a Qualified Opportunity Fund exists until the year on which such Qualified Opportunity Fund investment is sold or exchanged, or December 31, 2026, whichever occurs first. The maximum amount of the capital gain that may be deferred equals the amount invested in a 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. For amounts of the capital gains that exceed the maximum deferral amount, the capital gains are recognized and included in gross income.

At this time, additional guidance is needed to help explain some of the provisions for computing inclusion of deferred gain. The IRS has stated that guidance will be provided over the next few months. However, based on the current language, it appears that after the deferral period has run, and the gain deferred must be included in the taxpayer’s gross income computation, the amount of gain included equals the lesser of (1) the deferred gain amount or (2) the fair market value of the investment on the date the deferral period has run over the taxpayer’s basis in the investment. If a taxpayer's investment in the fund has depreciated, fair market value would be used; otherwise, it is anticipated that deferred gain be used for this computation.

Special basis computation rules apply to the fund investment. The taxpayer’s basis in the Qualified Opportunity Fund investment is initially zero because the taxpayer is investing untaxed gain. However, the taxpayer can elect to increase the basis depending on whether the investment is held for five or seven years based on a percentage of gain deferred. Further, for investments held for 10 years, the basis of the fund investment is stepped up to fair market value. Because 10 years will not run by the time deferral expires in 2026, taxpayers who are still holding their interest in the fund on December 31, 2026 are required to recognize and pay taxes on the deferred gain at that time, subject to any increases in basis they may have received for holding the property for five years or more. The amount included in taxable income would be added to the taxpayer’s basis in the fund. Again, for taxpayers looking for a long term investment in a Qualified Opportunity Fund that plan to hold the investment beyond December 31, 2026 for at least a total of 10 years, a benefit arises from the step-up in basis in the fund equal to fair market value. These taxpayers are not taxed on any appreciation at the time the interest in the fund is sold or exchanged. Hence, the basis rules are beneficial, and for appreciating investments, the 10-year exclusion rule is a potentially substantial tax savings and permanent exclusion for post-acquisition capital gains on investments in funds. Based on the foregoing deadlines, a taxpayer should invest sooner rather than later in order to take advantage of the longest deferral period possible, as well as any basis increases.

How Do I Certify That I Am an Investor in a Qualified Opportunity Zone?

The IRS has stated they will be issuing a form that will allow taxpayers to self-certify as a Qualified Opportunity Fund. After completing the form, it must be attached to the timely-filed income tax return for the tax year. In addition, an investor may make an election to defer the gain from the sale or exchange of their capital asset to an unrelated party as long as it is reinvested in a Qualified Opportunity Fund during the 180-day period, in whole or in part, when filing his or her 2018 federal income tax return in 2019. Hence, taxpayers make the election to defer on the return on which the tax on that gain would be due if the taxpayer was not electing to defer it.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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