IRS’s opportunity zone program is under way. It allows taxpayers to defer capital gains from the sale of business or personal property by investing the proceeds in opportunity funds to help development of low-income communities. This incentive was enacted under the new tax law, and many expect the program to be very popular.
New IRS guidance provides helpful rules. The proposed regulations, which clarify definitions and address some open questions and uncertainties, are a welcome relief for investors, fund managers and others awaiting guidance before actively moving forward with the new regime.
All sorts of taxpayers are eligible to participate: Individuals, C corporations, partnerships, S corporations, LLCs, real estate investment trusts, estates and more. To take advantage of the tax break, the gains must be invested in a QOF… qualified opportunity fund. A QOF is an entity that’s formed for the purpose of investing in qualified opportunity zone property and that holds at least 90% of its assets in such property. An entity Self-certifies as a QOF each year by attaching Form 8996 to its tax return. IRS’s regs provide more details on the rules to become a QOF. You have 180 days from the sale date to invest the gain proceeds in a QOF. You can invest all of your short or long-term capital gain proceeds from the sale or exchange of assets to an unrelated party in a QOF…or just part of the gains. Only the portion of the gains contributed to the QOF qualifies for deferral.
Taxpayers who opt to use this break must elect deferral on Form 8949, which they would file with their federal return for the year the capital gain is realized. In the case of pass-through entities such as partnerships, LLCs and S corporations, the election to defer capital gains may be made by either the entity or an owner. If the owner opts for deferral, then the 180-day period for investing gains in a QOF begins on the last day of the pass-through firm’s tax year in which the gain is realized.
Let’s turn to the main tax benefits from investing capital gains in a QOF: the gains are deferred until Dec. 31, 2026, or sales of the QOF, if earlier. Tax would generally be owed at that time on the deferral gains less the tax basis in the QOF Investment. There’s no limit on the amount of gains that can be deferred. The longer one holds a QOF investment, the more tax incentives there are. The investor begins with a zero-tax basis. If the QOF is held for at least five years, then the basis increases by 10% of the originally deferred gain, which essentially means that 10% of the deferred gain could gain could go permanently untaxed. If held at least seven years, then the tax basis is further increased by 5% of the gain that was originally deferred. And if the QOF interest is held for 10 or more years, taxpayers can elect to hike basis to fair market value at the time of sale, so that post-acquisition appreciation in the QOF isn’t taxed when the interest is sold.