New Investment Vehicle Created by the Tax Cuts and Jobs Act
In an effort to boost development in economically distressed communities, many federal incentive programs have been created over the years, such as the New Markets Tax Credit, Empowerment Zones, Renewal Communities, and more.
The Tax Cuts and Jobs Act (TCJA) of 2017 has created yet another incentive to invest in these areas, and the potential tax benefits are significant.
Qualified Opportunity Zones
Qualified opportunity zones (QOZ), as defined by the TCJA, are economically-distressed communities where new investments may be eligible for preferential tax treatment. Specifically:
- Deferral of gain recognition until the earlier of Dec. 31, 2026, or sale of investment
- Exclusion of 10 percent or 15 percent of the gain if the investment is held for five or seven years, respectively
- One hundred percent gain exclusion for investments held at least 10 years
Capital Gain Deferral
Under the new tax law, the tax on any gain (the statute references “any gain,” but congressional intent suggests that only capital gain would qualify) from the sale of property to an unrelated person can be deferred provided that the gain is invested in a qualified opportunity fund (QOF) within 180 days from the sale. The deferred gain will be recognized when the investment in the QOF is sold or Dec. 31, 2026, whichever is earlier.
In other words, the maximum deferral is until Dec. 31, 2026. Only the gain, not the total proceeds, need to be invested in the QOF. This is important because the income will be recognized even if the investment is not sold before Dec. 31, 2026. Therefore, it may be prudent in some circumstances to retain a portion of the cash to satisfy the future tax liability.
Reduction in Capital Gain
When an investor holds the interest in the QOF for five years, the investor’s basis in the investment is increased by 10 percent of the amount of gain deferred. For example, if an investor realized $100,000 of capital gain on a sale on Feb. 1, 2018, invested that $100,000 in a QOF on July 1, 2018 (within 180 days of the sale), and held that investment for five years, the amount of gain to be recognized would be reduced to $90,000.
If the investor holds the investment in the QOF for an additional two years (seven total), the investor’s basis in the investment will be increased by an additional five percent of the amount of gain deferred. Continuing with the example above, if the investor holds the QOF investment for at least seven years, the amount of gain to be recognized would reduce to $85,000.
Exclusion of Appreciation from Taxable Income
If an investor holds an interest in a QOF for at least 10 years, no gain will be recognized on the appreciation from the time of the initial investment. If the investor from the example above holds the QOF investment for ten years, the capital gain of $85,000 will be recognized on Dec. 31, 2026 (note that the amount included as gain will increase the investor’s basis in the QOF investment). Any further appreciation will be excluded from the investor’s income. If the investor sells the interest in QOF for $500,000 on July 2, 2028, the additional $415,000 of gain will be excluded from the investor’s income.
Qualified Opportunity Fund
A QOF may be structured as either a partnership or corporation, but it must invest at least 90 percent of its assets in certain property within a QOZ. There is no approval process from the IRS to become a QOF. Rather, each fund will self-certify that it meets the QOF requirements and attach the certification form to its tax return. Therefore, a taxpayer with significant gain may consider creating a QOF to invest in a single project within a QOZ.
There are many unanswered questions related to this new provision. Therefore, please reach out to your KSM advisor for assistance interpreting the legislation and determining relevancy for your situation.
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