Under the Tax Cuts and Jobs Act of 2017, new rules were established that allow taxpayers to defer capital gain from the sale of assets to unrelated persons by investing in a Qualified Opportunity Zone.

Qualified Opportunity Zones

Qualified Opportunity Zones are mostly high-poverty, low-income census tracts in which the federal and state governments wish to encourage investments. The aim is to spur economic development and job creation in distressed areas of the country.

In early 2018, governors of each state and U.S. territory nominated candidate zones, which were subsequently certified as Qualified Opportunity Zones by the U.S. Treasury Department as of July 1, 2018.

In Wisconsin, there are 120 Qualified Opportunity Zones involving areas in each of Wisconsin’s eight Congressional districts, reaching every part of the state.

Investing in a Quality Opportunity Fund

Taxpayers can defer the gain portion of the amount realized on a sale, and take back the basis portion as tax-free cash by investing the gain through a Qualified Opportunity Fund, which makes an investment in a Qualified Opportunity Zone.

The deferral includes both long-term and short-term capital gains from the sale of any property (not just sales of real estate), including marketable securities and closely held business interests.

A Qualified Opportunity Fund is any tax corporation or tax partnership that self certifies with the Internal Revenue Service. The investments can be in the form of either cash or property; however, property investments only get capital gain deferral to the extent of basis rather than fair market value.

Taxpayers have a 180-day time limit to reinvest into a Qualified Opportunity Fund. For individual and C-corporation taxpayers, the 180-day time limit starts on the date the capital gain is recognized. For taxpayers receiving capital gains from pass through entities (e.g., tax partnerships, S corporations, trusts, etc.), the taxpayers may elect to start the 180-day time limit on either the date the capital gain is recognized or the last day of the taxable year. For instances in which a taxpayer has a net section 1231 gain, the 180-day time limit starts on the last day of the taxable year.

The deferred capital gain that is the initial investment in a Qualified Opportunity Fund is taxable to the taxpayer upon the earlier of either the sale of the Qualified Opportunity Fund interest or Dec. 31, 2026. Additionally, the deferred capital gain that represents the initial investment in a Qualified Opportunity Fund is taxable upon a pre-2027 inclusion event, which generally includes any disposition that results in a reduction of the taxpayer’s beneficial interest in a Qualified Opportunity Fund.

Benefits and Time Periods

The beneficial tax treatment for the deferred capital gain depends on the holding period.

• If the taxpayer holds the Qualified Opportunity Fund interest for less than five years, then 100% of the deferred capital is taxed as a long-term capital gain (including any portion of the deferred capital gain that was initial short-term capital gain).

• If the taxpayer holds the Qualified Opportunity Fund interest for five years or more but less than seven years, then 10% of the deferred capital gain is forgiven and the remainder of the deferred capital is taxed as a long-term capital gain (including any portion of the deferred capital gain that was initial short-term capital gain). In order to receive this treatment, a taxpayer needs to make an investment in a Qualified Opportunity Fund prior to Dec. 31, 2021.

• If the taxpayer holds the Qualified Opportunity Fund interest for seven years or more but less than 10 years, then 15% of the deferred capital gain is forgiven and the remainder of the deferred capital is taxed as a long-term capital gain (including any portion of the deferred capital gain that was initial short-term capital gain). In order to receive this treatment, a taxpayer needs to make an investment in a Qualified Opportunity Fund prior to Dec. 31, 2019.

• If the taxpayer holds the Qualified Opportunity Fund interest for 10 years or more, then 15% of the deferred capital gain and all capital appreciation is forgiven and the remainder of the deferred capital is taxed as a long-term capital gain (including any portion of the deferred capital gain that was initial short-term capital gain).

Permissible Fund Investments

There are restrictions on the permissible investments that a Qualified Opportunity Fund can make. Every six months (typically on June 30 and Dec. 31), the fund must be 90% invested in Qualified Opportunity Zone Property. The fund can meet this requirement in one of two ways: by owning a Qualified Opportunity Zone Business Property or the equity interests of a Qualified Opportunity Zone Business.

In order to be considered Qualified Opportunity Zone Business Property, property must:

• be acquired by purchase or lease after Dec. 31, 2017, from an unrelated party;

• be originally used or substantially improved by the Qualified Opportunity Fund; and

• be located substantially (defined as 70%) within the Qualified Opportunity Zone.

Note that:

• The original use requirement applies to the use by the Qualified Opportunity Fund and not the property’s original use as a whole. Thus, a fund could acquire an existing business and relocate it in a Qualified Opportunity Zone, and that business’s assets would be considered originally used by the fund.

• Substantial improvement requires the Qualified Opportunity Fund to spend more on improvement of the property than the original acquisition cost over a 30-month period after the property is acquired. The basis in any land does not count when determining whether the substantial improvement test has been met.

• For real estate assets specifically, land and existing structures cannot be originally used in the Qualified Opportunity Zone, so substantial improvement is the only method by which a Qualified Opportunity Fund can have the property meet the second test for qualifying as Qualified Opportunity Zone Business Property. Further, substantial improvement can only be achieved through either a full renovation or demolition with ground-up development. If there is unimproved land in a Qualified Opportunity Zone, any structure that is built upon it and used by the Qualified Opportunity Fund will be considered originally used by the fund.

• Qualified Opportunity Zone Business Property only refers to tangible property; intangible property does not qualify as Qualified Opportunity Zone Business Property. The tangible property needs to be leased or purchased by the Qualified Opportunity Fund or the Qualified Opportunity Zone Business and have substantially all of its use (70%) in the Qualified Opportunity Zone.

Qualified Opportunity Zone Businesses

A Qualified Opportunity Zone Business must be either a tax corporation or a tax partnership, and it must qualify as a trade or business by reference to Section 162 of the Internal Revenue Code, except that ownership and operation of real estate qualifies for purposes of a Qualified Opportunity Zone Business (other than triple net leases). However, certain sin businesses are excluded from qualifying as a Qualified Opportunity Zone Business (e.g., golf courses, gambling parlors, liquor stores, etc.).

Substantially all (70%) of the tangible property owned or leased by a Qualified Opportunity Zone Business must be Qualified Opportunity Zone Business Property. Additionally, the Qualified Opportunity Zone Business must meet these criteria:

• 50% of the entity’s gross income is derived from the active conduct of a trade or business in the Qualified Opportunity Zone;

• a substantial portion (40%) of intangible property of the Qualified Opportunity Zone Business are used in the trade or business; and

• less than 5% of the average aggregate unadjusted basis of the entity property is non-qualified financial property (e.g., debt, stock, partnership interests, or other financial products).

Investments Worth Investigating

The Tax Cuts and Jobs Act of 2017 gives taxpayers an opportunity to defer capital gain from the sale of assets. To achieve the best results, taxpayers should be aware of the nuts-and-bolts of the program, which also allows investors to help turn around the most high-poverty, low-income areas in the U.S.

For more information, visit the FAQs on the IRS’ website.