An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation authority to the Internal Revenue Service.

The Tax Cuts and Jobs Act (TCJA) created Opportunity Zones to spur investment in distressed communities throughout the country by granting investors preferential tax treatment. Such investments must be made through Opportunity Funds, which are specially created investment vehicles that must have at least 90% of fund assets invested in Opportunity Zones.

The preferential tax treatment offered under the Opportunity Zone program is threefold:

  1. Investors can defer tax on capital gains invested into Opportunity Zones until no later than December 31, 2026 (gain must be reinvested within 180 days of the sale);

  2. If the investment in the qualified opportunity zone fund is held by the taxpayer for at least five years, the basis on the original gain is increased by 10 percent of the original gain. If the opportunity zone asset or investment is held by the taxpayer for at least seven years, the basis on the original gain is increased by an additional 5 percent of the original gain.

  3. Investors that hold the Opportunity Fund investment for at least 10 years can receive the added benefit of paying no tax on any realized appreciation in the Opportunity Fund investment.

Source: TCJA Conference Report – pages 923-926

https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions

How were Qualified Opportunity Zones (“QOZ”s) created and where are the tax benefits codified?

QOZs were created through the Tax Cuts and Jobs Act (P.L. 115-97), signed into law on December 22, 2017. Internal Revenue Code (“I.R.C.”) section 1400Z-1 defines a QOZ and provides procedural rules for the nomination and designation of QOZs. Internal Revenue Code section 1400Z-2 codifies the tax benefits related to QOZs.

Where are the QOZs located?

All QOZs have been designated at this time. The zones were nominated by State governors and were then approved by the IRS in May and June of 2018. There are over 8,700 opportunity zones located in all 50 states, the District of Columbia, and five U.S. possessions, comprising roughly 12% of U.S. land mass. The CDFI Fund provides a mapping tool showing all designated Opportunity Zones.

What is the purpose of QOZs?

Opportunity Zones are designed to incentivize long-term investments in economically distressed communities.

How does a taxpayer benefit from investing in a QOF?

Taxpayers receive preferential tax treatment in return for investing capital gain in Opportunity Zones through investment vehicles called Qualified Opportunity Funds (QOF). The benefit is two-pronged.

First, by making an eligible capital gain deferral on the IRS Form 8949, taxpayers can defer paying tax on the deferred capital gain until the earlier of gift/disposition or tax year 2026. The capital gain must be invested in a QOF within 180 days of the recognition. If the QOF investment Is held for 5 years, the taxpayer will receive a 10% step up on the deferred gain. If the QOF investment is held for 7 years, the taxpayer will receive an additional 5% step up on the deferred gain. To be able to get the total 15% step up, taxpayers must invest capital gains into a QOF by 12/31/2019. However, taxpayers may continue to invest in QOFs until 2026. The deferred gain will be taxed in 2026. The deferred capital gain will retain its character (for example, a short-term capital gain will be taxed as a short-term capital gain even though the deferral period may be longer than 1 year).

Second, if the taxpayer holds the QOF investment for 10 or more years, he or she will be eligible for a 100% step up in cost basis on the disposition (sale or exchange) of the QOF.

What are the 8 steps?

Investing in a QOF can be described in 8 simple steps:

  1. Realize capital gain (e.g., taxpayer sells corporate stock)

  2. Invest capital gain – taxpayer either creates or invests in an existing QOF within 180 days (the capital gain must result from a sale or exchange with an unrelated party within the last 180 days). Taxpayer makes a proper capital gain deferral election on Form 8949

  3. QOF invests in either Qualified Opportunity Zone Property (QOZP) or a Qualified Opportunity Zone Business (QOZB)

  4. Tax deferral à tax bill deferred until December 31, 2026 (unless sold/gifted prior to that date)

  5. 10% tax reduction à taxpayer holds the QOF for 5+ years

  6. 15% tax reduction à taxpayer holds the QOF for 7+ years

  7. Taxpayer pays the tax on the deferred gain in 2026 (85%, 90% or 100% of the gain taxed depending on holding period)

  8. Tax exemption – taxpayer holds the underlying QOF fund for 10+ years before selling it à no taxes on capital gain from appreciation of fund investment (100% step up in cost basis when you exit)

What ‘gain’ is eligible?

Gain that is treated as a capital gain for federal income tax purposes is eligible to be deferred into a QOF. The gain must be recognized prior to 2027 and must not be from a sale or exchange to a related person (siblings, parents, ancestors or lineal descendants). Eligible capital gain includes:

  • 28% collectibles gain

  • 28% 1202 qualified small business stock gain – to the extent unexcluded

  • 25% unrecaptured Section 1250 depreciation gain

o   Does not include depreciation recapture taxed as ordinary income (1245 gain)

  • Short-term capital gain

  • Long-term capital gain

  • Certain gains from Section 1256 contracts

  • Section 1231 gains

  • Long-term capital gain dividends from a REIT or a mutual fund

When does the 180-day period begin if a taxpayer is allocated a capital gain on the Form Schedule K-1 through a partnership?

The proposed regulations provide that a partner’s 180-day period begins on the last day of the partnership’s tax year, unless the partner elects to begin its own 180-day period on the date of the partnership’s sale or exchange. So if a calendar year partnership recognizes a capital gain but does not defer the gain, and the gain is then allocated to one or more partners, each partner would have the ability to defer the allocated capital gain by investing in a QOF. 180-day period for a partner in this example would begin on 12/31 of the year.

In the example above, what if the taxpayer has already filed his or her tax return without realizing that he or she had the ability to defer the capital gain into a QOF?

The taxpayer may file an amended tax return to make a proper capital gain deferral election on the Form 8949 if still within the 180-day period.

What are Section 1231 gains and how does the deferral of such gains work in the context of a QOF?

1231 property is depreciable property held by a business for over a year. To the extent 1231 gains exceed 1231 losses for the year, such gain will be treated as a LTCG. The first day of the 180-day period for investing 1231 gains into a QOF begins on the last day of the tax year.

Can you gift or donate an interest in a QOF?

Yes but these actions are considered an ‘inclusion event’ which means that the taxpayer would have to pay tax on the deferred gain. Also, if a taxpayer claims a loss for worthless securities with respect to a QOF investment, it would trigger tax on the deferred capital gain

What are examples of some transfers that won’t be considered an inclusion event?

Here are examples of some transfers that would not trigger a tax on the deferred gain:

  • Transfer of a QOF interest to a grantor trust will not be considered an inclusion event

  • Death is not an inclusion event – the estate or the heirs will be able to continue to defer the gain until the earlier of disposition of the QOF interest or 12/31/26

  • The holding period of an inherited QOF investment carries over to the heirs

Are there any restrictions on a Qualified Opportunity Zone Business?

The business cannot be a “sin business,” such as a country club, hot tub facility, racetrack, liquor store, golf course, suntan facility or a massage parlor.

Is there something that summarizes this?

Yes – you can watch a short EY video on QOFs – https://go.ey.com/OZ

Are there any resources on the topic?

Opportunity Zone Resources

Common Terms

  • OZ:  Opportunity Zone - an eligible census tract certified and designated as a Qualified Opportunity Zone

  • QOF:  Qualified Opportunity Fund – an eligible entity that files as a partnership or corporation for federal tax purposes, organized for the purposes of investing in Qualified Opportunity Zone Property and maintains at least 90% of its assets in QOZ Property

  • QOZ Property:  Property owned by a QOF that qualifies to be counted towards the 90% asset test

  • QOZ Stock:  Stock shares owned by a QOF that qualifies to be counted towards the 90% asset test

  • QOZ Partnership:  Partnership interest owned by a QOF that qualifies to be counted towards the 90% asset test

  • QOZ Business:  A trade or business where “substantially all” tangible property owned/leased is QOZ business property

  • QOZ Business Property:  Tangible property used in a trade or business, purchased after 12/31/2017, Original use or substantially improved, and substantially all of the use of such property is in OZ

Guidance

Forms and Instructions: