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Significant Tax Savings Available Using Qualified Opportunity Zones: Proposed Regulations Issued

Internal Revenue Service|Tax|Tax Reform

By Kirk Mitchell

The Internal Revenue Service (IRS) finally issued much needed guidance, in the form of proposed regulations, on Qualified Opportunity Zones (QOZs).  The guidance provides investors/taxpayers with an initial set of rules on how to qualify for the special tax break for investments made into Qualified Opportunity Funds (QOFs).  As noted in our article of July 11, 2018, investment in QOZs can provide three substantial federal taxpayer benefits to electing taxpayers:

  1. Immediate deferral of the gain from taxable income through December 2026;
  2. Permanent non-recognition of that gain up to 15% of the gain (meeting holding period requirements); and
  3. Permanent exclusion from income of future appreciation earned on the qualified investment (also meeting additional holding period requirements).

Utilization of the above provisions can substantially, and permanently, reduce the amount of overall federal taxes paid.  For example, the effective individual capital gains rate on the sale of capital gains assets be reduced from 20% to as low as 8.5%.  On total appreciation of $10,000,000 ($5m deferred gain and $5 additional appreciation), the cash tax savings could be $1,150,000.

The Tax Cuts and Jobs Act created QOZs effective as of January 1, 2018.  Members of Congress believe that the use of these zones will spur business investment, economic development, and job growth in economically disadvantaged areas throughout the United States (there are over 8,700 approved zones).  However, many taxpayers have been hesitant to begin taking advantage of the tax savings “opportunity” until the IRS provided additional operating rules.  As of Friday, October 19, the IRS provided the initial set of generally taxpayer-favorable rules.        

Key provisions in the proposed regulations include:

  • Clarification that QOZ incentives apply to electing “C” corporations, flow-through entities, and individuals who recognize any type of capital gain (short-term or long-term), triggered from the sale of property to an unrelated party, and within 180 days (as defined) invests the gain in a QOF;  
  • That deferred capital gains retain their character throughout the deferral period until ultimately recognized;
  • That QOZ benefits are only available to reinvestments of recognized capital gains;
  • A more strict definition of “related party” applies to QOZs than used elsewhere in the Internal Revenue Code;
  • Operational rules for the 180-day reinvestment requirement;
  • Reinvestment opportunities exist for an owner of a flow-through entity that itself fails to make the election to defer the gain;
  • QOF qualification and operating rules;
  • That additional QOF investments, over and above the investment of recognized gains, do not qualify for any of the QOZ benefits (though additional investment will not disqualify the QOF);
  • A QOF can be a newly formed or pre-existing partnership or corporation and that it self-certifies its eligibility;  
  • How owners track their tax basis in a QOF.

Taxpayers who want to take advantage of the tax benefits derived through investment in QOZs have a couple of options they can pursue.  They can choose to reinvest realized gains in QOFs established by third-party developers and investment advisors or they can choose to form and operate their own QOF.  QOFs need to be identified or formed well in advance of the expiration of the 180-day period to allow sufficient time to meet the gain reinvestment requirements. 

Further, the QOF also has its own requirements to invest the funds it receives into qualified opportunity zone businesses and properties in a timely manner.  Generally, the fund must invest at least 90% of its assets in qualified opportunity zone property.

The rules are new and are being analyzed in more detail.  However, this congressionally permitted form of tax-saving strategy is worthy of consideration.  Please contact Schneider Downs & Co., Inc. as soon as possible for assistance with the QOZ planning and compliance process

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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