The Tax Cuts and Jobs Act introduced a new concept into the tax law: qualified opportunity zones (Code §1400Z). The purpose of these zones is to induce investments in low-income communities by offering investors tax incentives. Qualified opportunity zone tax rules went into effect on Jan. 1, 2018. As yet, there are no existing investment opportunities, but here's what is known so far.

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Tax Breaks for Investors

Investors anywhere can take advantage of the tax breaks offered by making investments in qualified opportunity zones; they do not have to live or work within a designated area. For investments made by partnerships and S corporations, the tax breaks pass through to owners.

Gain on the sale of any property, such as securities, can be postponed by reinvesting it in a qualified opportunity zone (QOZ) within 180 days of the sale to an unrelated party. There is no dollar limit on how much gain can be deferred.

The deferred gain must be recognized by the earlier of the sale of the reinvestment in the qualified opportunity fund (explained later) or Dec. 31, 2026. The basis of the reinvestment is deemed to be zero, so all of the resulting gain is taxable. However, if the reinvestment is held for at least five years, the zero basis is increased by 10 percent of the gain originally deferred. If the reinvestment is held at least seven years, the basis is increased by another 5 percent of the deferred gain, for a total of 15 percent of the deferred gain.

Even though gain must be recognized no later than Dec. 31, 2026, if the reinvestment continues to be held past this tax recognition date, an investor can elect to use the fair market value of the property on the date of sale as the basis of the holding, provided it is held for at least 10 years. More specifically, the basis becomes the gain recognized on Dec. 31, 2026, plus the appreciation since this date. The bottom line is that investors can ultimately obtain tax-free gain. To maximize these tax breaks, investments in a QOF must be made no later than Dec. 31, 2019.

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Designated Zones

In June 2018, the Treasury Department certified over 8,700 QOZs. About 75 percent are within urban and suburban areas; the balance of them are in rural areas.

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Qualified Opportunity Funds

Investors cannot make direct investments in QOZs; they must invest through qualified opportunity funds (QOFs). These can be structured as a corporation or partnership (or a limited liability company treated as a corporation or partnership for federal tax purposes) designed to investment in qualified opportunity zone property. The QOF must put at least 90 percent of its assets into QOZ property. QOZ property can be QOZ stock, QOZ partnership interest, or QOZ business property. More specifically, QOZ business property is tangible property purchased after Dec. 31, 2017, the original use must commence with the QOF or the QOF substantially improves the tangible property, and during substantially all of the QOF's holding period for such property it is tangible property in a QOZ.

Proposed regulations (REG-115420-18, 10/19/18) flush out some of the rules for QOFs. For example, the proposed regulations provide that if at least 70 percent of the tangible business property owned or leased by a trade or business is QOZ business property, the requirement that “substantially all” of such tangible business property is QOZ business property can be satisfied if other requirements are met. If the tangible property is a building, the proposed regulations provide that a “substantial improvement” is measured based only on the basis of the building and not of the underlying land. But measuring a substantial improvement to the building by additions to the QOF's adjusted basis of the building does not require the QOF to separately substantially improve the land upon which the building is located (Rev. Rul. 2018-29). The substantial improvements must be completed within 30 months of the acquisition of existing property within the QOZ.

QOFs can self-certify that they are qualified opportunity funds using Form 8996, Qualified Opportunity Fund (a draft of which has been posted by the IRS). The form is also used to compute the penalty on any fund that drops below the 90 percent-asset-level requirement.

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State Tax Issues

Whether states will adopt the federal tax breaks for investors is unclear. It appears that New York will allow investors to obtain similar tax breaks (https://esd.ny.gov/opportunity-zones). “Generally, both the deferral and exclusion of the capital gains from federal income will flow through to New York State. This means those gains will also be deferred and excluded from New York taxable income.” But it is not certain whether this favorable treatment will be restricted to investments in QOZs within New York.

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Conclusion

There are still many open tax questions. For example, QOZs are set to expire at the end of 2028, so what happens to investors who hold onto investments after that date? What happens if the investor dies prior to recognizing the deferred gain at the end of 2026; is death treated as a disposition triggering gain recognition prior to 2026? And for investors, even after tax questions are settled, there are investment-type decisions that must be made before going into a QOF. Does the investment make sense? What are the minimum investment requirements? Fund fees? And more …

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.