- Thursday, December 5, 2019
Originally published in the California Tax Lawyer, Vol. 28, Issue 2
Authors: Kyle Recker and Alexander Loshiloff
Effective on December 22, 2017, as part of the Tax Cuts and Jobs Act, Congress enacted Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code.1 Section 1400Z-1 allows the chief executive officer of each state and United States possession to nominate a limited number of primarily low-income population census tracts for designation as “qualified opportunity zones” (“QOZ”), and it authorizes the Secretary of the Treasury to certify such nominations and officially designate QOZs across the United States and its possessions. Section 1400Z-2 offers, under certain conditions, significant tax benefits to taxpayers who invest in QOZs.
According to the Internal Revenue Service (the “IRS”), QOZs “are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities.”2 On July 9, 2018, the IRS published an official list of over 8,700 QOZs in all 50 states, the District of Columbia, and five U.S. territories (879 of such QOZs are in California).3 A map of all designated QOZs, along with the instructions on how to find a QOZ by address and census tract number, can be found on the website of the Community Development Financial Institutions Fund of the U.S. Treasury Department.4 That fund, however, will not be able to provide confirmation that a specific property is in a QOZ, so an interested party will need to consult the official list.
The primary tax benefit of Section 1400Z-2 is the manner in which it affects the taxation of capital gains. In general, for U.S. individual taxpayers, long-term capital gains from the disposition of capital assets held for more than one year are currently taxed at preferential rates of 0%, 15%, or 20%, depending on a taxpayer’s income tax bracket; short-term capital gains from the disposition of investments held for one year or less are taxed as ordinary income (there are presently seven marginal income tax brackets, with the highest rate at 37%).5 Capital gains may also be taxed by the state where the taxpayer lives. For corporations, under Code Section 11(b), the federal income tax rate currently is a flat 21% on both capital gains and ordinary income. Section 1400Z-2 modifies the above regime in three important ways.
First, a taxpayer can elect to defer tax on capital gain by investing the gain in a “qualified opportunity fund” (“QOF”)6 within 180 days of the sale or exchange. The deferred gain will become subject to taxation on the earlier of (i) the date on which the investment in a QOF is sold or exchanged in a taxable transaction, and (ii) December 31, 2026.
Second, if, prior to December 31, 2026, the QOF investment has been held for at least five years, there is a 10% exclusion of the deferred gain (in the form of a step-up in tax basis), and if held for at least seven years, there is an additional 5% exclusion (also in the form of a step-up in tax basis) for a maximum of 15% permanent tax exclusion of the initially deferred gain.
Third, if a taxpayer holds its appreciated investment in the QOF for at least 10 years (and makes an election at the time of sale to increase the tax basis in the investment to its fair market value), any gain on any post-acquisition appreciation in the value of the QOF investment is permanently excluded from tax.7
Example: On February 26, 2019, an individual U.S. taxpayer sells shares of stock to an unrelated party, giving rise to a capital gain of $10 million. The taxpayer elects to defer that gain and within the required 180-day period invests $10 million in a QOF. The taxpayer’s initial tax basis in the QOF investment is zero. After five years, the basis is increased to $1 million, or 10% of the initially deferred gain of $10 million. After seven years, the basis is increased to $1.5 million, or 15% of the initially deferred gain of $10 million. On December 31, 2026 (assuming that the fair market value of the QOF investment is then at least $10 million), the Section 1400Z-2 deferral period will end, and the taxpayer will be required to recognize $8.5 million of capital gain at that time ($10 million of the initially deferred gain minus $1.5 million of the tax basis) (and at that time, the taxpayer will need to come up with cash to pay the tax on that gain). At that point, the tax basis in the QOF investment becomes $10 million ($1.5 million of the tax basis as increased at seven years, plus $8.5 million of the gain triggered at December 31, 2026). The taxpayer sells the QOF investment for $19 million on January 1, 2030. Because the taxpayer held the QOF investment for at least 10 years prior to the 2030 sale, the taxpayer can make the election to increase the tax basis in the QOF investment to its fair market value at the time of the sale. Provided that this election is made, the $9 million post-acquisition gain is permanently excluded from tax ($19 million sale price – $19 million tax basis = $0 taxable gain). There is no dollar limit on how much post-acquisition gain can be excluded.
Note that some states that impose personal and corporate income tax have not implemented rules similar to the federal QOZ/OQF tax regime (including, as of August 26, 2019, California), and in those states, a taxpayer would not be entitled to defer taxation of capital gains at the state level. The state income tax implications should be carefully considered before making the decision to invest in a QOF.
Although Section 1400Z-2 seems to be fairly simple on the surface, its provisions are far from clear in terms of how they should be read in relation to one another and how they fit into the overall context of federal income tax rules. Fortunately, the IRS has issued two sets of helpful proposed regulations on which taxpayers, with a limited exception noted below, are permitted to rely (hereinafter, the “Proposed Regulations,” or “Prop. Treas. Reg. §”).8 This article is not an exhaustive technical analysis of the applicable rules; rather, its main purpose is to serve as a general guide to assist investors and their lawyers in navigating the statute and the Proposed Regulations in a comprehensible and systematic manner. Section II of this article describes certain important rules applicable to investors and their investments in QOFs, and Section III of this article describes the requirements applicable to QOFs.