Since the Tax Cuts and Jobs Act (TCJA) passed in December 2017, Opportunity Zones (O-Zones) have been a commonly misunderstood aspect of tax planning discussions. O-Zones (IRC Sec. 1400Z-2) provide certain tax benefits to taxpayers and were created to spur economic development and create jobs in economically distressed communities throughout the US and its territories.
All 50 states, the District of Columbia, and five US territories were authorized to nominate various census tracts for qualification as O-Zones. This nomination process was completed by June 2018 and published by the IRS via Notice 2018-48. Here’s an interactive map of all US O-Zones.
What are the Tax Benefits?
- Deferral of realized capital gain (CG) until as late as December 31, 2026
- Permanent exclusion of up to 15% of realized CG invested in a Qualified Opportunity Fund (QOF)—must recognize the other 85% of CG on December 31, 2026, or earlier if sold before then (CG retains its original character and is taxed at rates in effect in year recognized)
- 10% exclusion if QOF investment held for at least 5 years
- Additional 5% exclusion if QOF investment held for at least 7 years
- Permanent exclusion of all appreciation in your QOF investment if held for at least 10 years before disposition
- Note, not all states follow these rules—i.e., Oregon does; California does not
How Do O-Zones Work?
To qualify for the above tax benefits, you must invest any realized capital gain (or any portion up to 100%) in a QOF within 180 days of the date of sale. Any person or entity realizing a CG and meeting the requirements may elect deferral on their Form 8949 in the year of sale. If a pass-through entity doesn’t make the election, all or any portion of an owner’s distributive share can be elected to be deferred by that owner (here the 180-day period begins on the last day of the pass-through’s taxable year).
You may invest all proceeds from the sale, but only the CG portion will receive the above tax benefits. Called “Mixed Funds,” you must track deferred CG and other invested capital separately—two classes of ownership.
A QOF is an investment vehicle organized as either a corporation or partnership (including multi-member LLCs) for the express purpose of investing in qualified opportunity zone property (other than another QOF). Generally tested in six-month intervals, a QOF must hold at least 90% of its assets (Investment Standard) in qualified opportunity zone property, which only includes:
- Partnership interest
- Business property
Recently, the IRS released additional guidance around O-Zones that included proposed regulations, a notice, and a new IRS form. Some highlights of this recently released guidance include:
- QOFs self-certify their qualification via IRS Form 8996, filed annually with the OQF’s tax return to certify that it meets the Investment Standard
- In computing the Investment Standard, QOFs with published financial statements must use the asset values reported on them, while QOFs without use acquisition cost
- Pre-existing entities may qualify as a QOF
- A “reasonable working capital” safe harbor allows cash to be a qualified asset under the Investment Standard testing, but the cash must be fully spent by the QOF for the acquisition, construction or substantial improvement of qualified O-Zone property pursuant to a written plan within 31 months of receipt (essential relief for qualified property that has neither been acquired nor developed at the required testing periods)
- Guidance on “original use” requirement for land purchased after 2017 in O-Zones—essentially can exclude land basis when “substantially improving” real property (IRS Revenue Ruling 2018-29)
- Allow investors to sell or exchange a QOF investment and roll over the deferred gain into a new QOF investment
While the recently released guidance on O-Zones is welcome news, there are still many unanswered questions and concerns.
First, these regulations are only proposed and are subject to further revisions based on comments received by the IRS during the comment period. However, the IRS has stated that we may rely upon the proposed rules provided they are applied in their entirety and in a consistent manner.
Second, there are many questions surrounding the pure operation of a QOF and how its reporting and income tax implications conform to existing partnership and corporate tax law.
Lastly, and most importantly, a QOF is still an investment made by you. You need to evaluate its appropriateness to your overall situation, along with its related tax implications. You should vet the QOF’s investment strategy and operational details, as well as its sponsor, along with any other details you normally would for any other investment you make.
Proceed cautiously. While O-Zones can provide some significant tax benefits, both the QOF and you must meet all the requirements for 10+ years to maximize their full potential.
As you can see, O-Zones are a complicated endeavor. For the best advice for your situation, we always recommend you contact your tax professional.