Treatment of Capital Gains Reinvested in Qualified Opportunity Zones

The Tax Cuts and Jobs Act, which was signed into law on December 22, 2017, is the biggest overhaul to our Federal Income Tax Code.  It reduces tax rates, eliminates certain deductions, and enhances other deductions and tax credits.  One significant change is the treatment of capital gains invested in a qualified opportunity zone.

A qualified opportunity zone is a population census tract that is a low-income community.  Click here for information about qualified opportunity zones as well as a list of them.

Taxpayers that have taxable gain from the sale of any asset to an unrelated party may “elect” to defer the taxation of that gain if they invest it in a qualified opportunity zone within 180 days of the sale.  Only one election can be made with respect to a sale, and no election can be made after December 31, 2026.  The election allows a taxpayer to defer the taxation of the gain until the investment is sold or December 31, 2026, whichever is earlier.  The amount of gain that must be included in income is the originally deferred gain or the fair market value of the investment, whichever is less.

In order to encourage long-term investment, taxpayers also have the opportunity to permanently exclude from tax up to 15% of the original gain (the original investment in the qualified opportunity zone) and 100% of the appreciation (the growth of the investment).  Here’s how the rules work:

If a taxpayer holds the investment for at least 5 years, only 90% of the original gain is taxable (10% of the original gain permanently escapes taxation).  If a taxpayer holds the investment for at least 7 years, only 85% of the original gain is taxable (15% of the original gain permanently escapes taxation).  If a taxpayer holds the investment for at least 10 years, the taxpayer may “elect” to treat the tax basis of the investment as equal to the fair market value of the investment on the date it is sold and all post-acquisition gain totally escapes taxation.

Let’s review a few examples.

Example 1

On May 1, 2018, an investor sells property to an unrelated party and has a resulting gain of $500 thousand.  On July 1, 2018, the investor reinvests the gain in a qualified opportunity zone.  The investor sells its investment on July 2, 2021, for $800 thousand. Since the investor held the investment for less than 5 years, the investor must pay tax on the deferred gain of $500 thousand and the $300 thousand in appreciation.

Example 2

Assume the same facts as in Example 1 except that the investor sells the investment on July 2, 2025.  Since the investment is held for more than 7 years, the investor can exclude 15% of the original deferred gain.  Thus, $425 thousand of the deferred gain ($500,000 – $75,000) and the additional $300 thousand in appreciation are taxed, and $75 thousand escapes taxation.

Example 3

An investor invests $500 thousand of deferred gain in a qualified opportunity zone on July 1, 2024.  On December 31, 2026, the investor must pay tax on the entire $500 thousand deferred gain even though the investment has not been sold.  There is also no gain exclusion because the investment hasn’t been held for at least 5 years.  On July 2, 2034, the investor sells the investment for $1.25 million. Since the investment was held for at least 10 years, the investor may “elect” to treat the tax basis in the investment as $1.25 million and no additional appreciation is taxed.  If the investor does not make the election, $725 thousand is taxed ($1,250,000 – $500,000 previously taxed).

Example 4

Assume the same facts as in Example 3 except that the value of the investment has decreased to $300 thousand.  The investor will not make the fair market value election and instead gets to claim a $200 thousand loss ($300,000 – $500,000 previously taxed).

For those investors interested in long-term investment, tax reduction, and economic growth in low-income communities, the Tax Cuts and Jobs Act provides a very nice tax incentive to defer, reduce, and even eliminate the tax on gains from investment in qualified opportunity zones.

Be sure to check back soon for a follow-up article, because the Internal Revenue Service just issued proposed regulations that describe and clarify the requirements that must be met before a taxpayer can defer the recognition of capital gains invested in a qualified opportunity zone.

If you have any questions about this post or other related issues, please contact me at MDSlak@norris-law.com.