Under the Tax Cuts and Jobs Act (“TCJA”), a provision was enacted to spur economic development and job creation in distressed communities. Under Section 1400Z a taxpayer may elect to defer gain from the sale or exchange of any property to or with an unrelated person before December 31, 2026 to the extent such gain is reinvested in a “qualified opportunity fund” within 180 days after the sale or exchange. The new provisions require an electing taxpayer include such deferred gain in income upon the earlier of December 31, 2026 or the sale or exchange of the investment. IRC § 1400Z-2(b).
- The amount of gain to be included at such time equals the lesser of (i) the amount of deferred gain or (ii) the excess of (A) the fair market value of the investment on the date of inclusion over (B) the taxpayer’s basis in the investment. IRC § 1400Z-2(b)(2).
- A taxpayer’s basis in the investment is zero, but will be increased by the amount of gain recognized. IRC § 1400Z-2(b)(2)(B).
- If a taxpayer holds the investment for at least five years, its basis will increase by 10% of the deferred gain. Moreover, if the taxpayer holds the investment for at least seven years, its tax basis will increase by an additional 5% of the deferred gain, resulting in a maximum permanent exclusion of 15% of the deferred gain. IRC § 1400Z-2(b)(2)(B).
The Qualified Opportunity Zone provisions allow for deferral of gain only. Although the statute allows a taxpayer to invest amounts other than gain in qualified opportunity funds, if the investment is made with both gains as well as additional funds, referred to as “mixed funds,” then the investment is treated as two separate investments, and the Qualified Opportunity Zone rules only apply to the gain portion. IRC § 1400Z-2(e)(1).
Qualified Opportunity Fund:
A qualified opportunity fund is a corporation or a partnership organized for the purpose of investing in “qualified opportunity zone property”, that holds at least 90% of its assets in qualified opportunity zone property. IRC § 1400Z-2(d)(1). A qualified opportunity fund may be organized as a domestic or foreign entity, unlike qualified opportunity zone stock or a qualified opportunity zone partnership interest (both of which must be a domestic entity). IRC § 1400Z-2(d)(1). Qualified opportunity funds may not hold excess cash or other assets on the applicable testing dates. If the qualified opportunity fund does not meet the 90% requirement, the qualified opportunity fund will pay a penalty for each month that it fails to do so, unless such failure was due to reasonable cause. The amount of the penalty will be equal to the excess of (a) the amount equal to 90% of the aggregate assets, over (b) the aggregate amount of qualified opportunity zone property held by the qualified opportunity fund, multiplied by the underpayment rate in IRC § 621(A)(2) for each month. IRC § 1400Z-2(f)(1) and (3).
Qualified Opportunity Zone Property:
Qualified opportunity zone property is any property that is qualified opportunity zone stock, qualified opportunity zone partnership interests, or qualified opportunity zone business property. IRC § 1400Z-2(d)(2)(A). There are detailed rules defining each of these 3 categories of property.
The trap under these provisions is that the deferral of the gain appears to require payment of the tax upon expiration of the deferral period, without regard to whether or not the property is sold. The result is taxpayers both gamble upon the rates in place at the expiration of the deferral period as well as having the necessary funds to pay the tax in the future year.
These TCJA revisions are effective for taxable years beginning after December 31, 2017.
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