It’s hard to believe that tax reform was passed almost two years ago, and there are still aspects of it that tax preparers and the public are just beginning to understand. One aspect of tax reform that hasn’t received much attention until recently refers to Opportunity Zones. Section 1400Z, a new addition to the tax code, encourages taxpayers to invest in certain low-income communities called Qualified Opportunity Zones (QOZ). Moreover, taxpayers can defer and partially exclude taxes on the capital gains of QOZ investments when they reinvest in a Qualified Opportunity Fund (QOF). Here’s an overview of Opportunity Zones, the Qualified Opportunity Fund, and a primer on how to take advantage of the related tax benefits.
Overview of Opportunity Zones
Opportunity zones are new additions to the tax code, as of the end of 2017. At first, only 18 states had designated opportunity zones, and they went into effect in April 2018. Now, all 50 states, Washington, D.C. and five U.S. territories have designated opportunity zones. They are meant to spur economic development and add jobs in distressed areas, and any individual or business with capital gains can benefit. About 12 percent of U.S. census tracts are designated Opportunity Zones, according to the Tax Policy Center.
An opportunity zone is an economically-distressed community where eligible new investments could qualify for preferential tax treatment. States each submitted nominations for QOZs, which were then certified by the U.S. Treasury Secretary. You can view a map of all Opportunity Zones here (note: Flash must be enabled) or visit this webpage, which is run by the IRS, and scroll down to ‘Opportunity Zones’ to download a list in Excel. There are about 150 Opportunity Zones in Maryland.
In addition to real estate investments in Opportunity Zones, businesses that are located within a QOZ qualify for preferential tax treatment, too. To qualify, at least 50 percent of a business’s gross income must come from business activities within a QOZ. Businesses must recertify each year. There are three safe harbors a business can use to qualify, including:
- Hours-of-services-received test.
- Amounts-paid-for-services test.
- Necessary-tangible-property-and-business-functions test.
What Is a Qualified Opportunity Fund?
According to the IRS, “A Qualified Opportunity Fund is an investment vehicle that files either a partnership or corporation federal income tax return and is organized for the purpose of investing in Qualified Opportunity Zone property.” In other words, a QOF can be established to fund anything from commercial and industrial real estate, housing, infrastructure, and existing or start-up businesses. Qualifying real estate projects must result in the Opportunity Zone property being substantially improved.
To become a QOF, an eligible corporation, partnership, or LLC treated as a partnership or corporation for tax purposes must file Form 8996, Qualified Opportunity Fund, with its federal income tax return, for each year it intends to claim QOF tax benefits.
Tax Benefits of Opportunity Zones
There are three tax benefits of investing in an Opportunity Zone.
- Previously earned capital gains can be put into a QOF for temporary deferral of capital gains taxes. Existing capital gains taxes are not taxed until the end of 2026 of when the asset is sold or exchanged, whichever comes first.
- QOF investments held for five years or more qualify for a 10 percent exclusion on deferred capital gains. Seven years, and the basis step-up becomes 15 percent.
- QOF investments held for at least ten years qualify for a permanent exclusion in capital gains equal to the investment’s fair market value on the date the QOF is sold or exchanged.
Taxpayers can utilize one or more of the benefits.
There are additional proposed regulations the IRS published earlier this summer, and more guidance for private companies and individuals looking to take advantage of this tax benefit. Look for more posts on this topic that dive deeper into the details of Opportunity Zones. In the meantime, you can contact us anytime for guidance on this or any other tax questions.