The Tax Cuts and Jobs Act of 2017 brought several new opportunities to reduce your tax burden. A few previous options have been reduced or eliminated. First the bad news.
Like-kind exchanges are now limited to real estate. Capital gains in real estate can be deferred into a replacement property if complicated tax rules are followed. The same cannot be said for business property any more.
The good news comes to us in what is known as §1400Z-2 and §1016(a)(38) as added or modified by the Act. This might sound like a mouthful, but once you understand the implications your mouth is sure to start salivating. In a language normal people understand this means ALL capital gains can be deferred with some gains even tax-free at some point. It also means future gains (for a limited time only as we’ll discuss shortly) can be completely tax-free!
Your favorite accountant has received multiple requests to cover these new Opportunity Funds and Zones in detail due to the conflicting and limited information published elsewhere. In this post we will dig deep into the subject, unveiling the nuances you can use to take a serious bite from your tax liability.
We will also use multiple examples to illustrate available options in utilizing Opportunity Funds.
Opportunity Funds were created by the Act to encourage investment in economically disadvantaged areas of the country. To encourage investment in these areas Congress provided for zones that would have special tax advantages.
There are two major advantages when investing in Qualified Opportunity Funds:
- Tax deferral: Taxes on capital gains invested in a Qualified Opportunity Funds are deferred while the funds are invested in the Fund.
- Partial tax-free capital gains: Some of the capital gains deferred become tax-free in some instances (discussed later).
- Tax-free growth: Capital gains on investments in a Qualified Opportunity Fund become tax-free if held for 10 or more years.
Point 3 above comes with caveats we’ll discuss below. Deferred gains of the investment used to fund the Qualified Opportunity Fund need to be recognized on December 31, 2026 (or when the investment is sold, whichever comes first) even while the gains from the Fund investment continue deferring to the 10 year anniversary where they become effectively tax-free. Examples below should clarify.
You are allowed one temporary election to defer gain. In other words, you can use a portion or all of a gain to invest in a Qualified Opportunity Fund, deferring the gain, and the remainder is reported as gain with applicable taxes paid in the year realized.
You self-elect. Revenue may produce a new form to report this election which is attached to your tax return when you file. You have 180 days to invest the gains into a Qualified Opportunity Fund. The act of investing these gains into a Qualified Opportunity Fund within the 180 day window is your effective election. You will probably have a simple election button to click on your tax software to report the deferral instead of an additional form to fill out. Be sure to track your Fund investments manually if you change accountants or switch tax software.
The 180 day window to invest includes weekends and holidays. The Act is unclear on this issue, but it seems to indicate 180 calendar days rather than 180 business days, even if the 180th day falls on a holiday or weekend. There is no extension of the 180 window to the next business day.
Only gains are involved. Like-kind exchanges use a complicated formula to determine the amount required to be invested in the replacement property. With Qualified Opportunity Funds only the gains need to invested.
Example: You buy a piece of land for $100,000 and sell it in 2018 for $250,000. Only $150,000 of the sale is required to be invested in a Qualified Opportunity Fund to defer taxation on the gain.
Before we dig down into the details you should note there are several issues with the Tax Cuts and Jobs Act. In at least one section of the Code there is a reference to another section which makes no sense. We are left to assume what Congress meant if a reconciliation bill doesn’t correct the errors. The IRS will eventually write regulations on the ambiguous issues with the Tax Court determining the actual nature of the issues in question.
Another issues involves the IRS. Revenue promised clarification by late summer. As of this writing the IRS has not provided the form for self-certifying for those wishing to start their own Fund or additional guidance on how to handle many of these issues. The tax profession is left to determine the procedures with the risk regulations and/or the Tax Court may later determine differently.
I will note where the ambiguous issues reside as we review examples below. Taxes by nature have similar issues. Using Qualified Opportunity Funds to defer capital gains is something to consider. Just understand some details may change in the near future. Of course, the Tax Code can be modified at any time so stay tuned for updates.
The tax benefits from investing in a Qualified Opportunity Fund are significant with a bonus benefit.
- Any capital gains invested in a Qualified Opportunity Fund within 180 days of a realized capital gain is deferred until the investment is divested or December 31, 2026, whichever comes first. There is no limit on how much can be deferred. Caution! While the 10 year rule is still in effect, the tax deferral benefit ends December 31, 2026 and the original capital gain will be reported as income minus the basis adjustment discussed next. You are still required to hold the Qualified Opportunity Fund investment 10 years to receive tax-free status on the Opportunity Fund investment.
- Investments held in a Qualified Opportunity Fund for 5 years receives a 10% basis adjustment and a 15% basis adjustment for capital gains deferred into a Qualified Opportunity Fund for 7 years. Example: The wording of this tax benefit can be confusing. If you have an income property held for decades with the entire basis (except land) depreciated, the basis is rather low or even zero. However, for this adjustment we use the basis of the deferred capital gain. If $1 million of capital gain is deferred, $100,000 is added to basis after 5 years and $150,000 after 7 years, thereby reducing the deferred capital gain by 10 or 15 percent.
- There is a 10 year rule when investing in a Qualified Opportunity Fund to receive tax-free treatment of the capital gains from the Fund. Do not confuse this with the original deferred capital gains. Example: Using the above example, assume an $800,000 capital gain while invested in the Qualified Opportunity Fund over a 10 year period. The original capital gain is reduced by the 15% basis adjustment and reported (if held 7 or more years) when divested or on the 2026 tax return for calendar year taxpayers. The additional $800,000 capital gain from the 10 years invested in the Fund become tax-free.
- While the beauty of investing in Qualified Opportunity Funds involves the deferral of capital gains, there is nothing precluding someone from investing non-capital gains funds for 10 years to receive tax-free capital gains from the Fund. (Jake Drum, a reader, suggested the following edit: You will be able to contribute non-capital gain dollars to the Fund, but only the capital gains contributed will receive tax benefits. See his comment below with my response.)
Observations and Examples
The concept is simple in theory, but nothing in the Tax Cuts and Jobs Act is as simple as it seems. (A true statement of the entire tax code.) The details are important when such a long-term investment is required to receive tax benefits. Details of your personal situation can color the benefits of the program.
- Only one election can be made per sale or exchange. However, a temporary election can be made and a permanent election made later. The temporary election is the one made from gains invested in a Qualified Opportunity Fund where gains are temporarily deferred and the permanent election is made when you the sell an investment in a Qualified Opportunity Fund.
- Revenue will need to clarify the temporary and permanent election issues. It seems the one election limit prevents reinvestment of gains from the sale of a Qualified Opportunity Fund into another Fund.
- It is possible the gains from an installment sale would be limited to one temporary election only. This would limit the value of an installment agreement if deferral is desired.
- Section 1400Z-2(a)(1)(A) of the Code appears to be in error as it references the wrong section of the Code. There is a similar error in §1400Z-2(b)(1)
- If your investment in the Qualified Opportunity Fund declines the FMV is used to compute the gain after the deferral period ends, allowing for a reduction in the reporting of the deferred gain on your tax return. This effectively reduces your original capital gain.
Example: You defer $100,000 of gain by investing the gain in a Qualified Opportunity Fund. The investment declines by $10,000 at the time of sale. The reported original gain is now $90,000 ($100,000 deferred gain minus the $10,000 loss in the Fund).
- While nothing precludes an investment in a Qualified Opportunity Fund from non-gain sources, the basis of your investment in the Fund is zero with some exceptions. If the Fund is sold prior to the 10 year period all the sale price is considered gain. If you are considering an investment of non-gain funds you must be certain you will remain invested the entire 10 year period or your original investment will be taxed as well as the Fund investment profit.
- The only adjustments to basis is a 10% addition to basis after holding the Fund investment for 5 years and 15% after 7 years.
Example: A deferred gain (or non-deferred gain if you choose to do so) is given basis at the 5 and 7 year mark. If you invest $100,000 in a Qualified Opportunity Fund the basis is zero during the first 5 years, less a day. At 5 years the basis would be adjusted to $10,000, and $15,000 at 7 years. It also appears this only applies to deferred gains when the temporary deferral period ends December 31, 2026 and recognition of gain is required. An actual sale of your Fund investment would cause a circular computation negating the basis gains.
- If you invest gains and non-gains into a Qualified Opportunity Fund it is treated as two separate investments: deferred gains as one and other than gains invested as the other.
Example: You sell an asset with a $100,000 gain. You elect to defer $80,000 immediately by investing in a Qualified Opportunity Fund. Later you decide to invest the remaining $20,000 of the gain. Unfortunately, the one-election limit doesn’t allow deferral of the $20,000 portion on the Fund investment. The $20,000 does not qualify for deferral and must be included in income the year the gain was realized.
Example: Let’s go the other direction. You once again have a $100,000 gain. You instead invest $125,000 into a Fund. Only the $100,000 gain is deferred and considered one investment (the temporary election) and the additional $25,000 as another investment. This is true even if the investment was made in one combined sum.
- Once again, the temporary deferral period will be different from the permanent exclusion period. Deferred gains (if held to December 31, 2026) are reported on your 2026 tax return while the exclusion period of the Fund gain will continue for 10 years which means most deferred gain will be reported as income prior to the exclusion gains becoming effective due to the 10 year investment requirement.
Qualified Opportunity Funds are new and must invest at least 90% of Fund assets in Qualified Zone property. Qualified Zone property is located in low-income areas of the U.S. These untested investments could suffer significant losses in an economic downturn. There is also the risk new Funds are operated by unseasoned professionals.
Serious levels of due diligence is required before and investment is made in any Qualified Opportunity Fund.
Several Qualified Opportunity Funds have opened to date. Still, the choices available are lower than in many other asset classes. You can use a search engine to find Funds to invest in. The Fundrise Opportunity Fund is one such example of a Qualified Opportunity Fund.
Fundrise is not an affiliate nor affiliated with this blog, nor have I reviewed their portfolio. I make no claims as to the suitability of investing in Fundrise. It is advised you begin your search for a suitable Qualified Opportunity Fund as soon as possible. The 180 day investment window provides adequate time for in-depth review of Fund choices if you start early.
Starting Your Own Qualified Opportunity Fund
You can also start your own Fund to manage your deferred gains.
A Qualified Opportunity Fund must be a corporation or a partnership. (An LLC electing to be treated as such for tax purposes should pose no problem as it isn’t specified or excluded in the Code. An S corporation is not an option; only a regular corporation or partnership can be a Fund.)
Observation: A Fund can’t be organized for the purpose of investing in other Qualified Opportunity Funds. The IRS may provide future regs modifying this situation. As of this writing a Fund should not invest in another Fund.
Here is the best part of starting your own Qualified Opportunity Fund: you self-certify. Do you like that? The IRS will have a form by late summer (not yet available as of this writing) which you fill out and attach to your corporate or partnership return. It’s as simple as that.
Observation: Here is a map of the U.S. with all the Qualified Opportunity Zones listed. Starting your own Fund gives you some control over how your money is invested. However, you can only make investments in Qualified Opportunity Zones. You will need to zoom in to see the actual Zones.
What can your Fund invest in? Investments must be tangible property used in trade or business of the taxpayer and meet these three requirements:
- The property was acquired after December 31, 2017 in a Qualified Opportunity Zone.
- Use begins with the Fund or the Fund substantially improves the property. Substantial improvements are defined as additions to basis for the property after acquisition during a 30-month period where the basis is increased by an amount greater than basis at the beginning of the 30-month period. Example: Property has a $100,000 basis at the beginning of the 30-month period. Substantial improvements would require additions to basis of greater than $100,000 by the end of the 30-month period.
- Substantially all the use of the property must be within a Qualified Opportunity Zone.
Intangible property is not a qualified investment for a Qualified Opportunity Fund; only tangible property counts.
If you are running your own Fund you cannot make an acquisition for your Fund from a related party. There also appears to be errors in the Code in regards to related party purchases by a Fund. These errors will not negate the related party prohibition.
Some investments within a Zone are also prohibited: golf courses, massage parlors, hot tub facilities, country clubs, suntan facilities, racetracks and other gambling business and liquor stores.
One final consideration if you plan on starting your own Qualified Opportunity Fund. There are penalties if the Fund has less than 90% of assets invested in Qualified Opportunity Zones.
The IRS has answered some questions on the topic at hand. Keep in mind the IRS is not the final arbiter in these matters: the Tax Court is. You cannot use advise from the IRS as substantial authority. That is only gained from an enrolled agent, CPA, attorney, the Tax Code, Tax Court rulings and other qualified sources.
Deferring capital gains is easier than ever. While the like-kind exchange has been limited to real estate now, investing in a Qualified Opportunity Fund might be the best remaining option.
There is an argument where the like-kind exchange even for real estate might not always be the best choice. Investing gains in a Fund has more flexibility and liquidity in many cases. Coupled with the increases in basis and potential (if held for 10 years) of excluding all the gains from the Fund investment, a like-kind exchange is no longer an automatic choice for deferring gains.
This is a difficult topic with an easy to understand framework (invest capital gains in a Qualified Opportunity Fund for 10 years and defer 85-90% of the temporary gains until 2026 and the the remainder of the gains are excluded from income permanently.)
The details is where the tire meets the pavement. It would be a good idea to either print out this page or bookmark it for future reference. Unless your gains are a simple transaction the details will motivate your decision process.
I know this got technical. Regular readers normally expect a bit lighter reading. However, this has to be published. Too many people need the information as the traditional press is glossing over the subject and many tax professionals are still struggling with the implications of all the nuances of the Tax Cuts and Jobs Act. I have one more in-depth tax issue to address before we lighten the reading material for a family audience. Until then, take car, kind readers. May this lighten your tax burden at least a bit.
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