By Gregory S. Dowell
February 22, 2019
One area of the Tax Cuts and Jobs Act that is gaining more attention relates to investments in qualified opportunity zones. The basic advantages spelled out by Internal Revenue Code Section 1400Z-2 are as follows:
Treatment of gains
Temporary deferral – At the election of the taxpayer, gain from the sale or exchange of any property to an unrelated person is not included in gross income, to the extent of the investment in a qualified opportunity zone during the 180-day period beginning on the date of the sale or exchange. Gain from the temporary deferral is included in income in the earlier of:
- The year in which the investment is sold or exchanged; or
- December 31, 2026.
The amount of the gain that will be included is the lesser of the gain that was deferred, or the fair market value of the investment (in the event the value of the investment has depreciated).
Permanent exclusion – Gain from the sale or exchange of an investment in the qualified opportunity fund can be permanently excluded from income, again at the election of the taxpayer. Separate from funding the original investment (see temporary deferral above), this permanent exclusion election looks to the ultimate sale by the taxpayer of the qualified opportunity zone fund investment.
As an example, if a taxpayer sells property and realizes a gain of $1 million on March 1, 2019, and on March 31, 2019 (a date within the 180-day period) makes an investment of the $1 million gain in a qualified opportunity fund, the taxpayer can make an election not to include the $1 million of realized gain in the taxpayer’s gross income for 2019.
This is a temporary deferral on the gains so invested in a qualified opportunity zone. If a taxpayer makes the election to defer gain, the taxpayer has to include the deferred gain in gross income at the end of the deferral period.
A few important notes to keep in mind:
- No election can be made for sales or exchanges occurring after December 31, 2026.
- The Code Section 1400Z-2 applies to gains from the sale or exchange of any property and is not limited to the gains from the sale or exchange of a capital asset.
- There is no dollar limitation on the amount of the gain that can be deferred.
- Ownership in the qualified opportunity fund must be acquired in the 180-day period, not just entering into a contract to acquire an interest.
- Gains and funding could conceivably occur in two different years. In the case of a sales or exchanges that produce gains in the latter half of the year, a taxpayer may want to extend the filing date of the tax return until the investment in the qualified opportunity zone is made in the following year.
- It appears that any taxpayer (estate, trust, individual, corporation, partnership, etc.) can make the temporary deferral election.
- IRS has not yet made available specific instructions for making the temporary deferral election or the permanent exclusion election.
- No election can be made with respect to a sale or exchange if an election previously made with respect to the sale or exchange is in effect. This area needs more interpretation by the IRS, but appears to prevent a taxpayer from making successive temporary deferral elections with respect to the reinvestment of part of any gains from a sale or exchange in a qualified opportunity fund and the latter reinvestment of the gains from that same sale into a different (or even the same) qualified opportunity fund. Potentially, this limitation could also apply to gains from an installment sale that are invested; the one-election limit might prevent the taxpayer from making a second temporary deferral election in the second tax year.
Basis in the investment – The taxpayer’s basis in the investment is zero. If an investment is held for at least 5 years, the basis is increased by 10% of the amount of the gain that was temporarily deferred. If an investment is held for at least 7 years, the basis is increased by 15% of the temporarily deferred gain. The basis in the investment is further increased by the amount of gain recognized when the temporary deferral period ends; accordingly, if the taxpayer holds the investment until at least December 31, 2026, the basis in the investment increases by the remaining 85% of the temporarily deferred gain.
Using mixed funds to invest – Predictably, in cases where a taxpayer invests by using “mixed” funds (that is, some of the funds invested were the result of gains realized, while other funds not resulting in gains realized were also invested), the temporary deferral election, the gain inclusion rules, and the permanent exclusion rules apply only to the investments that resulted from the realization of gains.
Consistent with other aspects of the TCJA, at this stage of the game information is relatively sparse on some nuances of the law. We expect more updates to come as this provision gets more play by investors and developers.