When Opportunity Knocks to Defer Tax on Gains: “Qualified Opportunity Funds"

Kevin Matz, Esq., CPA, LLM (taxation)
Published Date:
Aug 1, 2018

The 2017 Tax Cuts and Jobs Act includes a new tax incentive provision that is intended to promote investment in economically distressed communities, referred to as “Opportunity Zones.” Through this program, investors can achieve the following three significant tax benefits:

1.   The deferral of gain on the disposition of property to an unrelated person until the earlier of the date on which the subsequent investment is sold or exchanged, or December 31, 2026, so long as the gain is reinvested in a “Qualified Opportunity Fund” within 180 days of the property’s disposition;

2.   The elimination of up to 15% of the gain that has been reinvested in a Qualified Opportunity Fund provided that certain holding period requirements are met; and

3.   The potential elimination of tax on gains associated with the appreciation in the value of a Qualified Opportunity Fund, provided that the investment in the Qualified Opportunity Fund is held for at least ten years.

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 Internal Revenue Service (IRS). All Opportunity Zones have now been designated, as of June 14, 2018, and are available on the U.S. Department of Treasury website. See https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx

A Qualified Opportunity Fund, in turn, is an investment vehicle that is established as either a domestic partnership or a domestic corporation for the purpose of investing in eligible property that is located in an Opportunity Zone and uses investor gains from prior investments as a funding mechanism. The investor can get the tax benefits of Opportunity Zones even if the investor doesn’t live, work, or maintain a business in an Opportunity Zone -- the investor just needs to invest in a Qualified Opportunity Fund. 

To become a Qualified Opportunity Fund, the entity self-certifies itself. The entity must meet certain requirements, in particular, a general requirement that at least 90% of its assets be “qualified opportunity zone property” used within an Opportunity Zone (as further discussed below), but no approval or action by the IRS is required. To self-certify, the entity merely completes a form which the IRS said it expects to release during the summer of 2018, and then attaches that form to the entity’s timely filed federal income tax return for the taxable year (taking into account extensions).

Deferral of Gain Through Timely Reinvestment in Qualified Opportunity Funds and Possible Exclusion from Income of Up to 15% of Such Gains If the Reinvestment Is Held for At Least 7 Years

To qualify for these tax benefits, the investor’s reinvestment in the Qualified Opportunity Fund must occur during the 180-day period beginning on the date of the sale. Under IRC section 1400Z-2(a)(2), the taxpayer may elect to defer the tax on some or all of that gain. If, during the 180-day period, the taxpayer invests in one or more Qualified Opportunity Funds an amount that was less that the taxpayer’s entire gain, the taxpayer may still elect to defer paying tax on the portion of the gain invested in the Qualified Opportunity Fund. If, in contrast, an amount in excess of the taxpayer’s gain is transferred to the fund (a so-called “investment with mixed funds”), the taxpayer is treated, for tax purposes, as having made two separate investments -- one that only includes amounts as to which the investor’s deferral election is made, and a separate investment consisting of other amounts. 

Importantly, the law requires only that the gain be reinvested in the Qualified Opportunity Fund, and not the total sales proceeds. Subject to clarification by the U.S. Department of Treasury and the IRS, it would appear that the gain deferred could potentially be any type of gain (e.g., short-term, long-term, ordinary, or otherwise) in connection with the disposition of property. 

In addition, in contrast to Section 1031 “like-kind” exchanges (another mechanism of gain deferral through reinvestment), in the Qualified Opportunity Funds context, the cash from the sale does not need to be specifically tracked or escrowed. Instead, the requirement is merely that an amount of cash equal to the gain on the sale be reinvested in a Qualified Opportunity Fund within 180 days of the property’s disposition.

The taxpayer’s basis in the Qualified Opportunity Fund is initially zero, but will be increased by 10% of the deferred gain if the investment in the Qualified Opportunity Fund is held for 5 years, and increased by an additional 5% (to 15% of the deferred gain in total) if the investment in the Qualified Opportunity Fund is held for 7 years. Thus, if a gain on the sale of property is timely reinvested in a Qualified Opportunity Fund, the taxpayer may be able to decrease the taxable portion of the originally deferred gain by 15% (via a corresponding basis step-up) if the investment in the Qualified Opportunity Fund is held for at least 7 years. 

The taxpayer makes an election to defer the gain, in whole or in part, when filing the tax return on which the tax on that gain would otherwise be due if it were not deferred.

Exclusion of Gain on Appreciation in the Value of Qualified Opportunity Fund If Held for At Least 10 Years

The tax incentives of this program go well beyond tax deferral (even putting aside the potential basis adjustments discussed above), as subsequent gain on the appreciation in the value of the Qualified Opportunity Fund is capable of being fully excluded from income. In order to qualify, the investor must hold its reinvestment in the Qualified Opportunity Fund for at least 10 years.

So When -- and How -- Can Investors Get Started?

As noted above, investors wishing to utilize this newly enacted opportunity zone program must timely reinvest their gain in a Qualified Opportunity Fund within 180 days following the disposition of the property giving rise to such gain. In order to satisfy the criteria for being an Qualified Opportunity Fund, 90% of the assets held by the fund on the last day of the fund’s taxable year (and on the last day of the first six-month period of the fund’s taxable year) must be qualified opportunity zone property within an Opportunity Zone, and the Qualified Opportunity Fund must have acquired the property after December 31, 2017. The Tax Cuts and Jobs Act delegates to the U.S. Department of Treasury and the IRS responsibility for establishing the mechanics of the certification process for Qualified Opportunity Funds. Hopefully, the IRS stays on target and releases its self-certification form for Qualified Opportunity Funds during the summer of 2018.  

Kevin Matz, Esq., CPA, LLM (taxation), is a partner at the law firm of Stroock & Stroock & Lavan LLP in New York City and a two-time prior chair of the NYSSCPA’s Estate Planning Committee. His practice is devoted principally to domestic and international estate and tax planning, and he is a Fellow of the American College of Trust and Estate Counsel (“ACTEC”) and a co-chair of the Taxation Committee of the Trusts and Estates Law Section of the New York State Bar Association. Mr. Matz is also a certified public accountant, in which connection he is currently the president of the Foundation for Accounting Education’s (FAE) Board of Trustees and the chair of the FAE Curriculum Committee. He writes and lectures frequently on estate and tax planning topics. He can be reached by email at kmatz@stroock.com or at 212-806-6076.

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