The Tax Cuts and Jobs Act (TCJA) has been in the news a lot lately, and with good reason. The TCJA provisions contain sweeping updates to many aspects of tax law, with at least something sure to affect every taxpayer. A few changes, such as the reduction in the corporate tax rate and the complementary deduction for certain pass-through income, have garnered the most headlines. However, arguably one of the most exciting provisions has not received much attention. This is the ability to defer and even permanently exclude certain capital gains when properly invested in Qualified Opportunity Zones.
The idea of Opportunity Zones is not new. Many may remember the Gulf Opportunity Zone (GoZone), established in 2005 to encourage investment in areas affected by hurricanes. However, in the past such zones were a bundle of sometimes confusing tax credits and deductions. The new law is unique in a couple of ways: first, the scope is national, with qualified areas in every state (and Puerto Rico), and second, investment is more straightforward…for tax law.
All that is needed to start is an investor with a capital gain. This can be any capital gain: long- or short-term, from the sale of stock or of real estate, etc. An amount of cash equal to the portion of the capital gain to be deferred must be invested in a Qualified Opportunity Fund within 180 days of the original sale date. A partial deferral can be achieved if only a portion of the gain is reinvested. In turn, the Qualified Opportunity Fund must invest in Qualified Opportunity property within the established zones. This can be stock, a partnership interest or qualified opportunity business property. There are limitations on the types of business that can qualify; for example, investment in a golf course or massage parlor is not allowed. Taxpayers can self-certify as a Qualified Opportunity Fund by filing a form (currently in development) with their tax return. Alternatively, there are many funds springing up that are looking for investors.
On day one, taxpayers start out with a fair market value equal to the invested gain, and a basis of zero. For example, if a taxpayer uses a $100,000 capital gain from the sale of land to invest in Qualified Opportunity Property, the fair market value of the property will be $100,000 but the cost basis will be zero. This means that if the property is immediately sold the $100,000 gain will be recognized. However, if the investment is held for 5 years, there will be a 10% basis boost. Now the gain if the property is sold will only be $90,000. Hold the investment for another 2 years (7 in total), and there is an additional basis boost of 5%. On December 31, 2026, deferred tax on the original gain is due. Assuming that the investment has been held for the required 7 years, this will be 85% of the original deferred gain. That means that 15% of the original gain will never be recognized. If the taxpayer keeps the original investment for at least 10 years, the property is bumped up to fair market value on the date of sale, and no post acquisition gain is recognized…ever.
Of course, there are more complications and nuances in the new law than are illustrated in this overview and interested investors must make sure they are meeting all of the requirements to achieve gain deferral and/or exclusion. Please contact your CSH advisor for more information on Opportunity Zones.