OPPORTUNITY ZONES. The Tax Cuts and Jobs Act of 2017 (the “Act”) provides for the designation of certain low-income community population census tracts as qualified opportunity zones and creates some tax incentives for those that have capital gains they would like to roll over into another investment on a tax-deferred basis to encourage investment in such qualified opportunity zones.
QUALIFIED OPPORTUNITY FUND. The Act allows a taxpayer 180 days in which to reinvest capital gains in a “Qualified Opportunity Fund”, which is a corporation or partnership organized for the purpose of investing in qualified opportunity zone property.
QUALIFIED OPPORTUNITY ZONE PROPERTY. “Qualified Opportunity Zone Property” includes any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.
DEFERRAL. Reinvesting the capital gains in a Qualified Opportunity Fund will allow taxpayers to defer the capital gains until the “Recognition Date”, which is the earlier of the date the “Qualified Opportunity Zone Property is disposed of, or December 31, 2026.
BASIS STEP UP ON THE RECOGNITION DATE. The taxpayer’s income tax basis in its rollover capital gains investment in the Opportunity Zone Fund is initially zero. If on the Recognition Date the taxpayer has held the Opportunity Zone Fund investment for 5 years, the taxpayer will get a 10% step up in the taxpayer’s income tax basis in its rollover capital gains investment in the Opportunity Zone Fund. If on the date the taxpayer recognizes the gain, the taxpayer has held the Opportunity Zone Fund investment for 7 years, the taxpayer will get an additional 5% basis step up for a total 15% step up in the taxpayer’s income tax basis in the rollover capital gains investment in the Opportunity Zone Fund.
BASIS STEP UP AFTER TEN YEARS. On the Recognition Date, the deferred capital gain is recognized, except for the basis step up. If the taxpayer holds the Qualified Opportunity Fund investment for at least 10 years, then the taxpayer may elect to step up the income tax basis in the Qualified Opportunity Fund investment to fair market value and not pay any income tax on the gains that result after the Recognition Date.
EXAMPLE. On July 1, 2018, taxpayer sells a capital asset in which Taxpayer has an income tax basis of $2,000,000 for $3,000,000, generating a $1,000,000 capital gain. Taxpayer invests $1,000,000 in a Qualified Opportunity Fund. On December 31, 2026, Taxpayer continues to own the Qualified Opportunity Fund investment, valued at $3,000,000. On September 1, 2029, Taxpayer sells its interest for $10,000,000. On December 31, 2026, Taxpayer gets a 15% income tax basis step up from $0 to $150,000. Taxpayer recognizes $850,000 in capital gain as of December 31, 2026, which further steps up its income tax basis to $1,000,000. On September 1, 2029, Taxpayer elects to step up its income tax basis to $10,000,000 and recognizes no gain from the $10,000,000 sale.
LIKE-KIND EXCHANGES. Before the Act, Internal Revenue Code §1031 was the main vehicle for rolling over capital gains. That Section allows taxpayers to roll over gains from the sale of investment property into other like-kind property, subject to certain rules regarding timing, identification of properties, character of properties and so on.
COMPARING 1031 EXCHANGES AND OPPORTUNITY ZONES. The table below has general comparisons of deferring capital gains using either a 1031 Exchange or Opportunity Zones.
|Use of property||Must be like-kind property||Do not have to be like-kind|
|Nature of property||Only real property, no personal property||Tangible property used in a trade or business, can be real or personal, and substantially all of it must be located in an Opportunity Zone|
|Identification of replacement property||Replacement property must be identified in 45 days, with limits on numbers of properties||No requirement|
|Closing on replacement||180 days||180 days|
|Proceeds that must be invested||Entire proceeds from sale||Only the gain from the sale|
|Partnership interests||Not allowed||Allowed|
|Stock in corporations||Not allowed||Allowed|
|Personal property||Not allowed||Allowed|
|Time of recognition of deferred gain||Upon sale of replacement property (unless further deferred in another like-kind exchange)||Earlier of sale of opportunity zone fund or December 31, 2026|
|Time of recognition of gain over and above deferred gain||Upon sale of replacement property (unless further deferred in another like-kind exchange)||Upon sale of opportunity zone fund unless held for more than 10 years, in which case there would be no gain|
|Income tax basis step up for holding property five or seven years||None||10% if 5 years before December 31, 2026, 15% if 7 years before December 31, 2026|
|Related parties||Not prohibited, but 2 year holding period after exchange required||Sale to related party cannot be deferred|