The 2017 tax act encouraged investment in certain low-income communities by promising deferral, and even forgiveness, of potentially substantial capital gains taxes to investors.

At the heart of these new tax incentives are Qualified Opportunity Zones, or QOZs. These economically challenged areas were nominated by states and certified by the Secretary of the U.S. Treasury. There are now thousands of certified QOZs across the United States and its territories.1 Taxpayers (including individuals, corporations, partnerships and trusts) who invest realized capital gains from the sale or exchange of assets into Qualified Opportunity Funds (QOFs) may become eligible for preferential tax treatment, including:

  • Deferral of capital gains tax recognition on the sale or exchange of the original investment
  • Forgiveness of capital gains taxes on as much as 15% of the original gain
  • Forgiveness of capital gains taxes on any new gain in the QOF

While these benefits are appealing, QOFs—like so many creatures of the Internal Revenue Code—are riddled with complexity. Investors considering QOFs should take care to ensure they understand both the risks and the rewards, and that they do so in conjunction with their tax professionals.

Robust Incentive

Unlike previous programs aimed at spurring investment in low-income communities, which often came in the form of limited tax credits, the QOZ approach allows for advantageous tax treatment on an unlimited amount of capital gain, realized from most any source, regardless of the taxpayer’s income level.

Here’s a closer look at the benefits QOFs offer:

Temporary Gain Deferral: A taxpayer can elect to defer recognition of an unlimited amount of capital gain from the sale or exchange of property with an unrelated person if that capital gain is reinvested in a QOF within 180 days.2

QOF Basis Adjustments: The Opportunity Zone provision rewards long-term investment—the longer a QOF is held, the bigger the benefit:

  • Year 0: A taxpayer’s basis in the QOF is initially zero
  • Year 5: If the taxpayer holds the QOF for at least five years, the basis in the QOF is increased by 10% of the original deferred gain, effectively resulting in forgiveness of 10% of the original gain
  • Year 7: If the taxpayer holds the QOF for at least seven years, the basis in the QOF is increased by an additional 5% of the original deferred gain, effectively resulting in the forgiveness of a cumulative 15% of the original gain.3

Recognition of Deferred Gain: The remaining gain may be deferred until the QOF is sold or exchanged, or until December 31, 2026, whichever comes first. At that time, the taxpayer recognizes tax on the original deferred gain (or the difference between the fair market value of the investment on the recognition date and the taxpayer’s basis, if that amount is less due to the aforementioned basis adjustments and/or negative investment performance).

Forgiveness of Tax on New Gain: A taxpayer holding a QOF for at least 10 years may elect to exclude from income all new capital gains arising from the QOF investment, whenever it is subsequently sold or exchanged.

How to Invest in Qualified Opportunity Zones

Only QOZ investments made through a QOF are eligible for the tax benefits. A QOF is any corporation or partnership organized to invest in QOZ property that elects QOF treatment when filing its income tax return. What qualifies as QOZ property is determined by layered definitions, but there are three threshold categories of QOZ property:

  • QOZ stock
  • QOZ partnership interests
  • QOZ business property

QOZ business property is, generally speaking, tangible property that a QOF buys or leases and uses as part of a trade or business in one or more QOZs. In order to qualify, either the original use of the property in the QOZ must commence with the QOF, or the QOF must substantially improve the property.4 QOZ stock and QOZ partnership interests are investments a QOF makes in subsidiary corporations or partnerships that themselves own or lease QOZ business property as part of a for-profit, operating trade or business in a QOZ.

A QOF must consistently hold at least 90%5 of its assets in QOZ property or face a material monthly penalty,6 and potential decertification as a valid QOF, unless reasonable cause for failure to satisfy this 90% test can be shown.

Any eligible taxpayer can self-certify to become a QOF with no IRS approval. The taxpayer merely needs to complete Form 8996 and attach it to a timely filed federal income tax return. Thanks to this ability to self-certify, many QOFs are closely held, capitalized with the gains of a few investors (who may be members of the same family, business partners, etc.). These investors usually have a specific business model in mind that they have personally selected and wish to execute within a QOF in order to qualify for the tax benefits.

Alternatively, some investors participate in syndicated QOF deals sponsored by existing players in the private equity and real estate markets. These syndicated deals aim to give investors exposure to multiple businesses or properties located in opportunity zones (although because the 2017 tax act prohibits a fund-of-funds structure, these offerings are typically structured as multiple QOFs, each housing one investment).

How We Can Help

The rules of the road for investing in QOZs are complex. If you are interested in learning more, please speak to your J.P. Morgan representative. We are available to work with you and your other professionals to help you find and evaluate opportunities that work for you.

 

Authors:

Thomas McGraw, Head of Tax Advisory

Jordan Sprechman, U.S. Wealth Advisory Practice Lead

 

Footnotes

1 These census tracts retain their status as opportunity zones for a 10-year period. A list of approved opportunity zones can be found in IRS Notice 2018-48, modified by Notice 2019-42.

2 To the extent a taxpayer invests more than gain realized from recent sales or exchanges into a QOF, the investment will be bifurcated into two investments—one eligible for QOF benefits, and another that is not. There is no tracing doctrine regarding the realized capital gain, so cash from any source may be able to be invested in a QOF.

3 In order to qualify for the incremental 5% step-up in basis, the QOF investment must have occurred no later than December 31, 2019 (seven years before the imputed recognition event on December 31, 2026). In order to qualify for the 10% step-up in basis, the QOF investment must occur no later than December 31, 2021.

4 Substantial improvement generally means making capital commitments that double the QOF’s cost basis in the property over a 30-month period.

5 Measured by the average percentage of QOZ property in the fund as measured on i) the last day of the first six-month period of the fund’s taxable year, and ii) the last day of the fund’s taxable year.

6 Equal to the underpayment rate published under I.R.C. § 6621(a)(2), applied on a monthly basis. The current underpayment rate is 5%.