One of the least-discussed but most-consequential provisions of the Tax Cuts and Jobs Act of 2017 is the Qualified Opportunity Zone program. Championed by a bipartisan group of U.S. Senators, “O-Zones” present investors with an opportunity to roll capital gains into a tax-preferred investment, with both tax deferral and permanent benefit features.
How does the O-Zone Strategy work?
- 1. A Taxpayer invests capital gains from the sale of an asset into a Qualified Opportunity Fund within 180 days of the asset sale. A Qualified Opportunity Fund is a fund which must hold at least 90 percent of its assets in Qualified Opportunity Zone Property. The Fund must file a form with the IRS after formation to designate itself as a Qualified Opportunity Fund, and must meet the 90 percent standard by the last day of the fund’s initial six months AND on the last day of each tax year. Investment in the Qualified Opportunity Fund can only be in the form of cash.
- 2. The Qualified Opportunity Fund must invest in Qualified Opportunity Zone Property. What is Qualified Opportunity Zone property?
- Property Located in an Opportunity Zone. Opportunity Zones are low-income communities nominated by individual states and approved by the Treasury Department as Opportunity Zones. A map of Opportunity Zones prepared by the CDFI Fund can be found here.
- Qualified Opportunity Zone Property comes in three forms:
- Qualified Opportunity Zone Stock – Stock in a corporation that must be a Qualified Opportunity Zone Business. Qualified Opportunity Zone Businesses are businesses ”in which substantially all of the tangible property owned or leased by the taxpayer is Qualified Opportunity Zone Business Property.” The business must adhere to the requirements under IRC 1397C(b)(2),(4),(8). Certain businesses such as massage parlors, gambling enterprises, golf courses, country clubs, tanning salons, or liquor stores are excluded.
- Qualified Opportunity Zone Partnership Interest – basically the same framework as Stock, above, but within a Partnership framework.
- Qualified Opportunity Zone Business Property – Tangible property acquired after 12/31/2017 and used in a Qualified Opportunity Zone trade or business. The use of property in the Opportunity Zone must originate with the Fund, OR, the fund “substantially improves” property. The Internal Revenue Code defines “substantial improvement” as follows – during any 30-month period beginning after acquisition date, additions to basis exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QO Fund, so long as “during substantially all of the QO Fund’s holding period of the property, substantially all of the use of such property was in a Qualified Opportunity Zone.”
- 3. The capital gain from the original asset sale is deferred until the sale of the Opportunity Zone Fund interest, subject to the following provisions:
- If the Investor holds the Opportunity Zone Fund interest for five years, the Investor receives a basis increase equal to 10 percent of the deferred gain, so long as the deferred gain was invested by December 31, 2021.
- If the Investor holds the interest for seven years, the Investor receives an additional basis increase of 5 percent in addition to the 5-year/10-percent increase above, so long as the deferred gain was invested by December 31, 2019.
- If the Investor holds the interest for 10 years beyond December 31, 2026, the Investor receives a step-up in basis in the Opportunity Fund equal to fair market value.
- If the Opportunity Zone Fund interest is held as of December 31, 2026, the Investor must pay the tax due on the deferred gain, less the basis increase from the 5 and/or 7-year hold.
- An Investor cannot invest deferred capital gains after December 31, 2026.