Welcome to the Land of OZ

Welcome to the Land of OZ

By David DuWaldt

October 22, 2019

Now that I got your attention, no, this is not a mystical journey down the yellow brick road to Emerald City. This is about investments into Opportunity Zones (“OZs”). The Tax Cuts and Jobs Act of 2017 added Subchapter Z to the Internal Revenue Code, which provides certain tax benefits for making such investments. OZs are defined as economically distressed communities where new investments may be eligible for preferential tax treatment. The tax related incentive for making investments into OZs come in the form of a deferral of tax on recognized capital gains, including a partial reduction in such gains based on the holding period of the investment.

To illustrate the tax benefits, let’s assume the following fact pattern: On August 31, 2019, shares of stock of a C corporation were sold for $10 million by a stockholder and the tax basis which the stockholder had in the stock was $5 million. Within 180 days from the date of the stock sale, the stockholder can invest the gain portion ($5 million) into a Qualified Opportunity Fund (“QOF”), which is an entity that invests into OZs, and defer the payment of tax on the capital gains. In addition, if the investment in the QOF is held more than 5 years, the tax basis in the investment increases by 10% of the deferred gain ($500 thousand in this example) and, if the investment is held for more than 7 years, the tax basis in the investment increases by an additional 5% of the deferred gain ($250 thousand in this example). In 2026, the tax on the remaining deferred capital gain is reported on the tax return (i.e., tax on capital gain of $4.25 million in this example) even if the investment in the QOF is not sold. If the stockholder continues to stay in the investment, for at least 10 years in total, gain from a sale of the investment in the QOF is not taxable.

For any significant tax strategy, it is important to pay close attention to the details in order to avoid some disqualifying event or issue with the fact pattern. Here are some of the requirements connected with OZs:

  • The qualifying gain that is intended to be deferred must be capital gain, not ordinary income. The capital gain requirement does include Section 1231 gain.
  • The qualifying gain that is intended to be deferred cannot be the result of a sale to a related party.
  • The type of taxpayers that qualify for this tax treatment is quite broad to include not only individuals but also corporations, partnerships, trusts, estates, real estate investment trusts, and regulated investment companies.
  • As alluded to in the example above, starting from the date of sale that gives rise to the gain to be deferred, an investment into a QOF must be completed within 180 days.
  • The QOF must hold at least 90% of its assets in qualified opportunity zone business property. The type of property that meets this requirement includes both tangible personal property and real property.
  • As for business structure, the QOF can be a C corporation, an S corporation or a partnership.
  • If the QOF invests in a business operation, at least 50% of the gross receipts must be derived from the active conduct of a trade or business in OZs.
  • Such active businesses cannot include a golf course, a country club, a racetrack or similar facility used for gambling, a liquor store, a hot tub facility, a massage parlor, or a suntan facility.
  • The investment in the QOF must be sold before January 1, 2048 to receive the gain exclusion tax treatment.

Before making an investment into a QOF, it is wise to seek the advice of a competent tax professional.