Key takeaways:

• The 2017 Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to provide a tax incentive for private, long-term investment in economically distressed communities.
• Investors in these programs are given an opportunity to defer and potentially reduce tax on recognized capital gains.
• Tax savings are only available when investors retain the investment in the Qualified Opportunity Fund for the time frame stated.

What this may mean for you:

• If you are facing a significant tax liability as a result of capital gains, investing in a Qualified Opportunity Fund may be worth exploring, provided you invest within a prescribed amount of time.

What is an Opportunity Zone?

An Opportunity Zone is a community nominated by the state and certified by the Treasury Department as qualifying for this program. The Treasury Department has certified zones in all 50 states; Washington, D.C.; and U.S. territories. A list can be found at the U.S. Department of Housing and Urban Development.

How does this program work?

The Opportunity Zone program allows for the sale of any appreciated assets such as real estate or stocks, with a reinvestment of the gain into a Qualified Opportunity Fund. Unlike a 1031 Exchange, there is no requirement to invest in a like-kind property to defer the gain. 

To defer a capital gain (including net §1231 gains), a taxpayer has 180 days from the date of the sale of the appreciated asset, to invest the realized capital gain dollars into a Qualified Opportunity Fund, an investment vehicle that files either a partnership or corporate federal income tax return and is organized for the purpose of investing in a Qualified Opportunity Zone. The fund then invests in Qualified Opportunity Zone property.

The taxpayer may invest the return of principal as well as the recognized capital gain, but only the portion of the investment attributable to the capital gain will be eligible for the exemption from tax on further appreciation of the Opportunity Zone investment, as explained below.

Note that a taxpayer who receives a reported capital gain from a flow-through entity, such as a partnership, an S-corporation, or a trust/estate, has the option to start the 180 day investment period on any of the following dates:

• the last day of the entity taxable year;
• the same date that the entity’s 180 day period begins; or
• the due date for the entity’s tax return, without extensions, for the taxable year in which the entity realized the eligible gain. 

Qualified Opportunity Fund 

A Qualified Opportunity Fund is any investment vehicle that is organized as a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone property (other than another Qualified Opportunity Fund) that holds at least 90% of its assets in Qualified Opportunity Zone property.

Similar to other investments, an investment in a Qualified Opportunity Fund may increase or decrease in value over the holding period. In addition, income may be paid on this investment. Given that the purpose of the program is to improve particular areas, it is expected that the fund will continue to invest in the improvement of the property in which it is invested. Cash flow may occur once the property improvements are complete and the property is leased or sold to third parties.

Because Qualified Opportunity Funds are income tax planning tools and are investment options for taxpayers, these investments may involve risk. Like many other types of investments, the risks may potentially include market loss, liquidity risk, and business risk, to name just a few. Because this investment may not be appropriate for all investors, consult with your investment advisor before pursuing such an investment to determine if this fits with your risk profile and diversification of your investments.

Qualified Opportunity Zone property    

Qualified Opportunity Zone property is used to refer to property that is a Qualified Opportunity Zone stock, a Qualified Opportunity Zone partnership interest, or a Qualified Opportunity Zone business property acquired after December 31, 2017, used in a trade or business conducted in a Qualified Opportunity Zone or ownership interest in an entity (stock and partnership interests) operating with such tangible property.

Conceptually, the Qualified Opportunity Fund must bring property new to the entity to be used in the Opportunity Zone. A fund that simply acquires property already being used in the zone will not qualify without substantial improvement. Substantial improvement requires improvements to exceed the Qualified Opportunity Fund’s initial investment into the existing property over a 30-month period. (Note: investment only applies to the amount paid for the building.)

For instance, if a Qualified Opportunity Fund acquires existing real property in an Opportunity Zone and $1 million, of the purchase price is allocated to the value of the building, the fund has 30 months to invest an amount greater than the $1 million building value for improvements to the property in order to qualify for this program.  Certain businesses, such as golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, race tracks or other facilities used for gambling, and liquor stores, are prohibited for Qualified Opportunity Fund investments.

Tax deferral and savings

A Qualified Opportunity Fund investment provides potential tax savings in three ways:

Tax deferral through 2026 -A taxpayer may elect to defer the tax on some or all of a capital gain if, during the 180-day period beginning at the date of sale/exchange, they invest in a Qualified Opportunity Fund. Any taxable gain invested in a Qualified Opportunity Fund is not recognized until December 31, 2026 (due with the filing of the 2026 return in 2027), or until the interest in the fund is sold or exchanged, whichever occurs first. In addition, the deferred gain has the potential to be reduced as described below.

Step-up in tax basis of 10% or up to 15% of deferred gains - A taxpayer who defers gains through a Qualified Opportunity Fund investment receives a 10% step-up in tax basis after five years and an additional 5% step-up after seven years. Thus, the taxpayer needed to invest by December 31, 2021 to be eligible for the 10% step-up in tax basis, and invest by December 31, 2019 for the additional 5% step-up in tax basis.   If the taxpayer will have held the investment in the fund for seven years at the end of 2026, the taxpayer would qualify for the 15% increase in tax basis.  Due to the rule regarding recognition of gain no later than December 31, 2026, the step-up in tax basis benefit was no longer available for new investors beginning with the 2022 tax year.

No tax on appreciation - Perhaps the most significant tax benefit of the program, remaining in the Qualified Opportunity Fund for at least 10 years results in the cost basis of the property being equal to the fair market value on the date of sale/exchange.

1. Tax deferral through 2026
   
   The gain deferral applies to any investment gain (for example, the sale of appreciated stock or a business). It is important to note that the tax cannot be deferred indefinitely — only until 2026. The tax savings, however, may still be significant. Qualifying for deferral does not require an intermediary, and the taxpayer has 180 days from a sale to invest the gains into a Qualified Opportunity Fund.
   
   Example 1 : In July 2019, a taxpayer sold a zero-basis business for $10 million, resulting in a $10 million capital gain. The taxpayer invested the entire amount in a Qualified Opportunity Fund within 180 days. None of the sale proceeds were taxable in 2019. At 2019 federal capital gains rates of 20%, this allowed the taxpayer to keep over $2 million that would otherwise have been taxed as a capital gain and paid in the 2019 tax year.  Instead the funds were invested in the Qualified Opportunity Fund. Assuming even a conservative rate of return on that $2 million, it could provide a significant return to the taxpayer over the length of the investment.
2. No tax on 10% or up to 15% of deferred gains
   
   Example 2 : Given the same situation as the previous example, after five years, the taxpayer is given a $1 million basis in the fund (10% of the original capital gain deferred). After seven years, the taxpayer is given another $500,000 of basis in the fund (5% of the original capital gain deferred). After seven years, hypothetically the taxpayer sells the $10 million investment and would pay tax on only $8,500,000 of the gain. At current federal capital gains rates, that’s a savings of over $300,000 simply for holding the investment for seven years.
   
   
3. Investing in a Qualified Opportunity Zone in 2025
   
   Although the contribution deadline for the step-up in basis provisions have passed, the Qualified Opportunity Zone still provides taxpayers the ability to defer the capital gains. A taxpayer may defer the gain until the earlier of 2026 or when the investment is sold.  Plus, tax on the appreciation from the Qualified Opportunity Zone investment (if any) would be avoided if the investment is held for over 10 years. 
   
   What if there is a loss in value in the Qualified Opportunity Fund?
   The taxpayer is still eligible for the increase in basis for holding the investment for five or seven years, so long as they met the previously described investment deadlines. The taxpayer’s recognized gain for 2026 (or the year of divesting from the fund) will be the lesser of the original deferred gain or the fair market value of the fund interest reduced by the taxpayer’s adjusted basis in the fund, if any. Because of the complicated nature of these investments and the complicated rules that are associated with it, please consult your tax advisor before committing any funds.  The example below is simplified for illustration purposes only.
   
   Example 3 : Again, given the same situation, after seven years, the Qualified Opportunity Zone property is sold at a loss. Let’s presume the taxpayer realizes $8 million from the Qualified Opportunity Fund (80% of the original investment). Because the taxpayer held the investment for seven years, the taxpayer receives a 15% increase in basis, or $1,500,000. The gain realized would be $6,500,000 ($8,000,000 - $1,500,000).
   
   
4. Potentially no tax on appreciation
   
   Example 4 : In 2019, a taxpayer makes a $10 million investment in a Qualified Opportunity Fund. In 2030, the taxpayer sells the investment for $15 million. The $5 million in appreciation is not taxable. At current federal capital gains rates, that’s a savings of over $1 million. The taxpayer will, however, have phantom income (taxable income without corresponding sale) on the original $10 million investment in 2027 for the 2026 tax year because the investment in the fund was held beyond December 31, 2026, when the deferred gain on the original investment must be recognized.
   
   For each example: This information is hypothetical and is provided for illustrative purposes only. It is not intended to represent any specific strategy, nor is it indicative of future results.
   
   

Conclusion

Qualified Opportunity Funds remain an option for deferral of capital gains as long as you are able to retain the investment for the noted time frames. Keep in mind that depending on any future tax legislation, capital gains rates at the time of sale in 2026 could be at a higher rate than in 2025. Taxpayers should seek the advice of their professional legal and tax counselors when considering a Qualified Opportunity Zone investment.

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Source: Internal Revenue Service. (28 April 2022). Opportunity Zones. https://www.irs.gov/newsroom/opportunity-zones