Using Opportunity Zones
One of the more innovative provisions in the 2017 Tax Cuts and Jobs Act (TCJA) provided for the creation of Opportunity Zones. Using the Internal Revenue Code to drive policy or incentivize action is nothing new, but the sheer size of the economic enticement for investing in these designated areas is something worthy of special attention.
Qualified Opportunity Zones (QOZs) allow keen investors and developers to turn redevelopment opportunities into tax savings while fulfilling a need for community reinvestment and renewal. These QOZs were selected based on local, regional, and state priorities that aligned with economic development and revitalization efforts.
Why is this new law helpful?
It permits taxpayers (including individuals, C-corporations, S-corporations, LLCs, partnerships, decedents’ estates, and trusts) to defer realizing capital gains by re-investing them in a Qualified Opportunity Fund (QOF) within 180 days of the sale or exchange resulting in the capital gain. A QOF is a corporation or partnership established to invest in QOZ property that holds at least 90% of its assets in QOZ property.
Opportunity Zone Development
Because driving development and reinvestment in low-income communities were the key reasons for creating the Opportunity Zone legislation, there are certain checks in place to ensure those goals are met. For example, QOZ business property is tangible property used in the trade or business of a QOF that:
- Was acquired by the QOF by purchase after December 31, 2017;
- The original use of which began with the QOF or the QOF substantially improved the tangible property; and
- Substantially all of the use of the tangible property must be in a QOZ during substantially all of the QOF’s holding period of the property.
Property is considered to have been substantially improved only if additions to the value of the property (i.e., capital expenditures), during any 30-month period beginning after acquisition, exceed an amount equal to adjusted basis of the property at the beginning of the 30-month period.
When a QOF purchases a building in a QOZ, substantial improvement to the building is determined by measuring the QOF’s additions to the basis of the building, not the land upon which the building is located. Therefore, no separate calculation or improvements are specifically required for the land itself. This enables developers to purchase older, dilapidated buildings and restore them to their prior glory without needing to develop the land.
Benefits of Investing in an Opportunity Zone
Many developers typically defer gains through 1031 like-kind exchanges, but investing in Opportunity Zones may make more sense given its additional tax-advantaged treatment. Making a deferral election and placing recently acquired capital gains in a QOF may benefit the taxpayer through:
- Deferral of capital gains on the initial sale until the earlier of the sale of one’s interest in the QOF or December 31, 2026
- Step-up in cost basis by 10% of the deferred gain if held at least five years and by 15% of the deferred gain if held at least seven years
- The ability to make a basis step-up election after ten years of holding the QOF interest, which would allow for the permanent exclusion of post-acquisition capital gains upon the sale or exchange of one’s interest in the QOF
The Time Frame: Take Action Before Dec. 31, 2021
Investors must finalize a QOF investment before the end of 2021 to take advantage of the 10% increase in basis. In order to take advantage of the 15% increase in basis, investors must finalize their QOF investment by December 31, 2019. Given the amount of time it takes to complete due diligence, if you would like to take advantage of this heightened reduction, the time to act is quickly approaching.
Finally, and perhaps most importantly, if a taxpayer holds a QOF investment for at least ten years, the taxpayer may make a second election that increases the basis of the QOF investment to the fair market value of the investment at the time it is sold or exchanged, thereby excluding all post-acquisition capital gains.
Though we know the time frame for making a deferral or step-up election, we are still awaiting Treasury guidance on the method of making such election.
Taxpayer sold X stock, having a cost basis of $9,000, for $10,000 on January 1, 2019, realizing $1,000 in capital gains from the sale.
- On May 30, 2019, to defer the tax on capital gains, Taxpayer made an Opportunity Zone election and invested the $1,000 gain into the stock of a QOF.
- Taxpayer’s initial basis in the QOF investment is zero because no tax has been paid to date on the gain.
- In 2024, five years from investment, the cost basis in the QOF interest is increased to $100, being 10% of the deferred gain.
- If Taxpayer continues to hold the investment until 2026, seven years from investment, the basis is increased by another 5% to $150.
- On December 31, 2026, when the initial tax is triggered on the deferred gain, the fair market value of the QOF investment is $3,000. Instead of having to recognize $3,000 or even $1,000 in the initial deferred capital gains from the sale of X stock, Taxpayer will now only recognize $850. After paying the capital gains tax from the initial investment, the basis in the QOF stock is now equal to $1,000.
If Taxpayer continues to hold the investment until at least 2029, ten years from the initial investment, Taxpayer may then make an additional election upon sale to step-up the cost basis to the fair market value of the interest, thereby excluding all post-acquisition gain. Thus, Taxpayer will incur capital gains of only $850 for the life of the investment, which gains were not only deferred for seven years and reduced by 15% but were then able to grow tax-free on the resulting appreciation until sale.
Opportunity Zones in Virginia
All told, 8,761 tracts are currently classified as Qualified Opportunity Zones throughout the U.S. In Virginia, 212 QOZs are spread throughout the Commonwealth and include areas in and around Roanoke, Blacksburg, Richmond, Lynchburg, Charlottesville, and Hampton Roads.
An area’s QOZ designation will last for ten years, but the benefits may last much longer. Under proposed regulations, the basis step-up election for those QOF investments held for at least ten years may be made until December 31, 2047.
Many of the QOZs are in or near areas ready for development, and it is likely that investors and developers will take this opportunity to revitalize these communities. As the Treasury Department releases final rules for Opportunity Zones, Woods Rogers looks forward to assisting stakeholders hoping to take advantage of these new opportunities.
Please contact our team of Tax attorneys if you would like to know more about Opportunity Zones.