Most savvy investors are aware of the capital gains tax deferral that arises from a properly structured tax-deferred exchange under Section 1031 of the Internal Revenue Code (“Code”). Under the recent tax law changes of 2017, however, tax-deferred exchanges are now limited solely to interests in real estate.

The 2017 tax law change meant that deferring recognition of gain under Section 1031 of the Code from the sale of other capital assets is no longer available. However, what Congress takes away it may return in another manner. Such is the case with the creation of tax advantages for the investment of gain in “Qualified Opportunity Zones.” See IRC Section 1400Z.

Subject to the requirements below as a result of an investment in a Qualified Opportunity Zone, a taxpayer can defer immediate recognition of the gain, and, depending on the holding period, get a reduction in the amount of gain realized through a basis adjustment and possibly eliminate tax on the realized appreciation in the value of the interest/assets held in a “Qualified Opportunity Fund.”

A Qualified Opportunity Zone is an economically distressed community that has been designated as a “qualified opportunity zone.” The CDFI has provided a map of the Qualified Opportunity Zones. Here’s another helpful interactive map.

How it works

To meet the requirements for the preferential tax treatment, the investment of gain must be made in a “Qualified Opportunity Fund” within 180 days of the date of the sale or exchange that generated the gain. This fund should be structured as either a partnership or a corporation set up for the purpose of investing in qualified opportunity zone property. The taxpayer will need to self-certify that it is a Qualified Opportunity Fund by completing an IRS form that has not been issued yet.

The Qualified Opportunity Zone Fund then makes an investment in a qualified opportunity zone business that holds at least 90% of its assets in a Qualified Opportunity Zone.

If the taxpayer holds an interest in the Qualified Opportunity Zone Fund for at least five years, then the taxpayer receives an increase in basis in the investment equal to 10 percent of the deferred gain invested in the Fund. Holding for seven years increases basis by an additional 5 percent of the deferred gain invested in the Fund. Note that if the investment is held for seven or more years then only 85 percent of the initial gain will be subject to capital gains tax. The period of capital gain tax deferral ends on the earlier of the date the investment is sold or December 31, 2026. If the investment is held longer than 10 years, the taxpayer will get a step up in basis in the interest in the Fund equal to the then fair market value.

An example

This table provides an example of how the Opportunity Zones could work for a taxpayer-investor.

Year 1

Year 1

Year 5

Year 7

Year 8 (December 31, 2026)

Year 10

Investor sells a mutual fund for a $1 million gain.

Within 180 days of the sale, the $1 million is invested in the fund.

Investor receives a 10% ($100,000) step up in basis, reducing taxable gain to $900,000.

Investor receives an additional 5% ($50,000) step up basis, reducing taxable gain to $850,000.

Tax on deferred gain, now $850,000 is due.

Investor's sale of interest in fund should be equal to the fair market value of the investment and as a result the sale should be tax free.

In this scenario, because of her long-term investment in Opportunity Fund, this taxpayer has the benefit of deferring tax on the gain and also is able to exclude 15 percent of her original gain from taxation. And after 10 years, she can sell or exchange her investment in the fund without paying any taxes.

There are many more additional requirements and technicalities to utilizing the Opportunity Zone tax deferral, but the foregoing example provides an overview of this new program.

Summary of the Opportunity Zone process

  • If gain is recognized from the sale of real estate, a tax-deferred sale under Section 1031 of the Code may still be preferable to some clients because there is no restriction on where you can re-invest.
  • Gain from the sale of a capital asset other than real estate may benefit from an investment in an Opportunity Zone, if that investment will appreciate in value over time. As is often stated, it is better to pay the capital gains tax than to lose the gain in a bad subsequent investment.
  • Consider the edges of Opportunity Zones in areas that interest you. For example, it may be that one corner of an intersection is within an Opportunity Zone, while the other 3 are not and have substantial investment already in place. This may lower the risk for the new investment.

The Treasury Department is anticipated to release proposed regulations for Opportunity Zones which should provide some additional detail on the requirements for this investment vehicle.