Part 3 – The Opportunity Zone Tax Benefits Explained
If you’ve made it to Part 3 of this Series, then you already know that the economic upside of the opportunity zone program lies in the following three categories of tax benefits: (1) the deferral of tax on capital gains that are timely invested in qualifying opportunity zone projects and businesses; (2) a reduction in those deferred capital gains due to a favorable “step-up” in basis after holding the qualified opportunity fund investment for at least five years; and (3) the exclusion of all capital gains arising from the appreciation in value of the qualified opportunity fund investment if held for at least ten years. Each of these benefits is addressed in turn below:
First, taxpayers may elect to defer recognition of capital gains that are invested into a qualified opportunity fund (QOF) within 180 days of the event or transaction giving rise to the capital gain. Those deferred gains will not be recognized until the earlier of (i) the sale of the QOF investment (or another transaction or event that is described in the regulations as an “inclusion event”) or (ii) December 31, 2026. Inclusion events listed in the regulations include a variety of transfers and other corporate or partnership events and transactions that are beyond the scope of this post. With respect to the December 31, 2026 recognition date, QOF investors need to keep this in mind and ensure that they have sufficient cash or other liquid assets to pay the capital gains taxes once the previously-deferred gains are recognized.
Second, all QOF investments made with deferred capital gains proceeds initially have a tax basis of zero. However, the opportunity zone statute provides for two potential step-ups in basis that reduce the amount of the deferred capital gains subject to future recognition. The first step-up, of 10% of the QOF investment, occurs after the taxpayer has held the investment for five years. The second step-up, of 5% of the QOF investment, occurs after the taxpayer has held the investment for seven years; however, in light of the full inclusion of deferred gains no later than December 31, 2026 as noted above, this 5% step-up is only available for QOF investments made before January 1, 2020. Thus, not only has the taxpayer deferred recognition of the original capital gains upon making the QOF investment, but the taxpayer can decrease the amount of that gain that will be recognized by 15% (or 10% for investments made after December 31, 2019).
Third, if the QOF investment is held for at least ten years, then upon sale or liquidation of the investment, taxpayers can elect to have the basis in the investment stepped up to full fair market value, as a result of which all of the appreciation in value from inception through liquidation is excluded from recognition for federal income tax purposes. This is the most attractive tax benefit that investors are seeking with opportunity zone investments.
To illustrate the above benefits, here is a very simplified example:
Assume that a taxpayer: (1) sells appreciated property in a transaction that would generate a capital gain of $100; (2) elects (after December 31, 2019) to defer the $100 of gain and timely invests $100 into a QOF; and (3) holds the QOF investment for more than ten years, at which time the taxpayer sells the investment for $400 and elects to have the basis in the investment stepped up to fair market value (the full $400). The taxpayer would: (1) not recognize any of the $100 dollar gain until December 31, 2026; (2) recognize a gain of $90 on December 31, 2026, being the original $100 of deferred gain reduced to reflect the 10% step-up in basis after five years (note that the second 5% step-up is not available since the 7-year anniversary of the QOF investment would be after December 31, 2026 when all deferred gains must be recognized); and (3) recognize no additional gain upon the sale of the QOF investment for $400 after ten years as a result of the basis step-up to fair market value at that time. Thus, the taxpayer would recognize gain on $90 and would recognize no gain on the remaining $310 of realized value.
For a more in-depth discussion of the opportunity zone program, including the statute, proposed and final regulations, please read our Opportunity Zones Client Alerts which you can access via the following link: https://www.martinllp.net/category/opportunity-zone/
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While this Series will serve as a helpful primer on the opportunity zone regulations and compliance framework, the devil is always in the details. If you are considering making an opportunity zone investment in the near future, or just want to learn more than this primer can offer, the attorneys at Martin LLP are always available to consult with you.
In the meantime, stay tuned for Part 4!