Opportunity Zones: How to Defer Capital Gains

Disclaimer:

The following information is not intended to be written advice concerning Federal tax matters subject to the requirements of Treasury Department Circular 230.

The information that follows is general in nature and is not intended to apply to any individual or entity’s particular circumstances. Although the information provided is intended to be timely and accurate, we cannot guarantee its accuracy on future dates. No individual or entity should act on this information without the advice of a professional and careful consideration of the particular circumstances.

Opportunity Zones: the basics

Opportunity zones were introduced by the Tax Cuts and Jobs Act of 2017. The law allows for gains from the sale of capital assets to unrelated parties to be deferred by reinvesting them into a Qualified Opportunity Fund (QOF). If elected, after 10 years, post-acquisition gains (i.e., appreciation on the reinvested amounts) may go unrecognized indefinitely.

Qualified Opportunity Funds are investment funds of which 90% or more of the assets are:

• Qualified Opportunity Zone stock
• Qualified partnership interests
• Other qualifying business property

Any corporation or partnership that meets the requirements may self-certify to the IRS that they are a qualified opportunity fund.

A Qualified Opportunity Zone is a low-income area that is recommended by a state and approved by the Secretary of the Treasury. Qualified Opportunity Zones maintain their designation for 10 years. Each state has a limited number of Qualified Opportunity Zones.

A “low-income community” is defined in the Internal Revenue Code and is based on median family income in a community relative the surrounding metropolitan area or state.

How to defer capital gains using an Opportunity Zone

If a taxpayer has a gain from the sale or exchange of a capital asset to an unrelated person, the taxpayer may elect a partial gain deferral on their personal tax return. This is done by reinvesting part or all of the gain into a Qualified Opportunity Fund within 180 days of the sale of the asset. A full deferral on the post-acquisition gains is allowed after 10 years.

Deferred gains that are reinvested into a qualifying fund have not been taxed and have not been recognized, so the taxpayer has no basis in the Qualified Opportunity Fund. After five years of investment, the taxpayer is given a percentage of the original deferred gain as basis.

• After five years, the taxpayer is given 10% of the amount of the deferred gain as basis in the Qualified Opportunity Fund.
• After seven years, the taxpayer is given an additional 5% of the amount of the deferred gain as basis.
• After ten years, the basis of the investment is equal to its fair market value on the date of sale or exchange. This will all be deferred gain recognized no later than December 31, 2026, plus all post-acquisition gains on the reinvested amount.

The December 31, 2026, deadline

Currently, the deferred gain provision does not extend beyond December 31, 2026, which means taxpayers are not guaranteed the opportunity to hold an investment for seven years. The percentage of deferred gains not yet permanently deferred by the five and seven year rules will be recognized on December 31, 2026, even if the investments remain unsold.

EXAMPLE: An individual sells a capital asset on October 1, 2019, and recognizes a capital gain of $100,000. This individual then elects to reinvest the entire $100,000 gain into a Qualified Opportunity Fund on February 28, 2020. On December 31, 2026, this taxpayer will have only been invested in the Qualified Opportunity Fund for 6 years and 10 months. Therefore, this taxpayer will only have permanently deferred 10% of the capital gain (or $10,000). The remaining $90,000 will be recognized, which results in an equal increase in basis going forward.

However, any post-acquisition gain on the reinvestment may be unrecognized if the investment continues for more than 10 years, regardless of the December 31, 2026, deadline.

EXAMPLE: Assume the same facts as the prior example. In addition, the individual does not sell the Qualified Opportunity Fund until 2031. At that time, the original $100,000 reinvestment has appreciated $20,000 to a fair market value of $120,000. Because the fund was held for more than 10 years, the $20,000 of appreciation is not recognized when sold in 2031. Since 90% ($90,000) was recognized on December 31, 2026, the realized transaction in 2031 has no gain. The basis is $120,000 and the sale is $120,000.

Qualified Opportunity Fund defined

As discussed above, a Qualified Opportunity Fund is an investment fund of which 90% or more of its assets are Qualified Opportunity Zone stock, partnership interests, or other qualifying business property. Any corporation or partnership that meets the requirement may self-certify to the IRS that they are a Qualified Opportunity Fund.

Theoretically, this means any individual could form an S-Corp, partnership, or an LLC (taxed as a corporation or partnership) and invest 90% or more of it’s assets into Qualified Opportunity Zone property. Therefore, if you are aware of property in a Qualified Opportunity Zone , have capital gains, and have the time to manage an investment in property, theoretically, you could do this yourself.

A Qualified Opportunity Zone business must earn at least 50% of its gross income from business activities within a Qualified Opportunity Zone. The regulations provide three safe harbors that a business may use to meet this test:

• Hours-of-services-received test
  • At least 50% of the services performed, based on hours, by the employees and independent contractors of a business are performed within the Qualified Opportunity Zone.
• Amounts-paid-for-services test
  • At least 50% of the services performed, based on the amounts paid for the services, by the employees and independent contractors of the business are performed within the Qualified Opportunity Zone.
• Necessary-tangible-property-and-business-functions test
  • The tangible property of the business that is in a Qualified Opportunity Zone and the functions (management or operational) performed for the business in the Qualified Opportunity Zone are each necessary to generate 50% of the gross income of the trade or business.

Qualified Opportunity Zone defined

Each potential Qualified Opportunity Zone is a tract of land defined by the Census Bureau that is roughly the size of a neighborhood. These zones are designated by the Secretary of the Treasury after a nomination process for each zone is started by the governor of the state in which the tract resides.

To qualify for nomination by the governor, a tract must generally be considered a “low-income community.”

To be considered low-income, the community has to meet one of the following conditions:

1. The community has a poverty rate of at least 20%.
2. The community is in a high-migration, rural area and has a median family income ≤ 85% of the statewide median family income.
3. The community is outside a metropolitan area and has a median family income ≤ 80% of the statewide median family income.
4. The community is within a metropolitan area and has a median family income ≤ 80% of the statewide median family income or the metropolitan area, whichever is greater.

No more than 25% of low-income communities in a state may be designated as a Qualified Opportunity Zone, and the designation as a QOZ, once approved, lasts for 10 years.

Qualified Opportunity Zones exist in all 50 states and many U.S. territories, including Puerto Rico.

How to find a Qualified Opportunity Zone

If you’re looking to manage your own Qualified Opportunity Fund, you’ll need to find a Qualified Opportunity Zone to invest in. This may sound complicated, but the IRS has actually made this very straightforward.

First, the IRS has provided a PDF with a list of the current QOZs. This list displays opportunity zones by state, county, and census tract number. So, if you already know an area you’re looking to invest into, this is a convenient way to search.

IRS Qualified Opportunity Zone List

Second, the Community Development Financial Institution (CDFI) manages a map that displays opportunity zones. This map will display non-qualified opportunity zones as well as current Qualified Opportunity Zones by default.

To only see the current QOZs, click the Layers tab on the right-hand side of the screen, select “Opportunity Zone Tract,” and unselect “2011-2015 LIC Census Tract.” The map will display the zones once you have sufficiently zoomed in to an area. Qualified Opportunity Zones are displayed in blue, and all of the zones will display a pop-up with various information about them if you click on the zone.

CDFI Qualified Opportunity Zone Map

Finally, the CDFI provides a spreadsheet of current QOZs. This list is convenient if you’re looking to begin your own sheet or are more comfortable with excel than a PDF.

CDFI Qualified Opporunity Zone Spreadsheet

More information on Qualified Opportunity Zones and other important tax topics

Gleim wants to keep all of your accounting knowledge current, so we’re constantly creating new resources. Our CPE courses will help you learn more about current tax or accounting topics, refresh old topics, and provide you with plenty of topics to fulfill your CPE requirements.

Also, be sure to check out our Accounting Explained: QBID article to learn everything you need to know about the qualified business deduction.

Finally, if you’re looking to learn something specific about Qualified Opportunity Zones we didn’t cover here, check the IRS’s Opportunity Zone FAQs.

This Article was reviewed by Garret Gleim

Garrett W. Gleim, CPA, CGMA, leads production of the CPA, CMA, CIA, and EA exam review systems at Gleim. He holds a Bachelor of Science in Economics with a concentration in Accounting from the Wharton School, University of Pennsylvania. He is a member of the American Institute of Certified Public Accountants (AICPA) and the Florida Institute of Certified Public Accountants (FICPA). Also an active supporter of the local business community, Garrett serves as an adviser to several startups. He is an avid pilot and is certified as a flight instructor and commercial pilot.