Reducing Your Tax Bill Through Opportunity Zone Planning

The Opportunity Zone program was enacted to encourage taxpayers to realize gains on appreciated assets and invest such gains in low-income areas to facilitating economic growth. A taxpayer who recognizes capital gains and who, within 180 days, invests the capital gain into a qualified investment vehicle (an “opportunity fund”) may elect to defer the portion of the original capital gain until December 31, 2026. One benefit is that up to 15% of the capital gain may be excluded from income taxation entirely, and up to 10% can be excluded if the taxpayer holds at least five years on such date and an additional 5% if the taxpayer holds at least seven years. In addition, if a taxpayer holds his or her opportunity fund interest for at least ten years, any appreciation in the opportunity fund interest is generally exempt from US federal income taxation.

As a follow-up to our earlier post, the Treasury issued proposed regulations on opportunity zones, answering some questions, and seeking additional comments on others. The proposed regulations provide clarity on several questions raised by the legislation but leave others unanswered.

Entitles Investing in Opportunity Funds: The proposed regulations provide that partnerships, C corporations, REITS, individuals, and LLCs can invest in opportunity funds. A partnership can elect to defer its capital gain by investing in an opportunity fund, in which case the partnership will pay the gain at the time it must be recognized, either when the interest in the fund is sold or on December 31, 2026. Individual partners can also elect to defer their gain, and such an election can be made within 180 days of the end of the partnership’s tax year in which the gain is recognized (as opposed to 180 days from the date the asset is sold). However, the regulations do not address situations in which both the partnership and the partner have decided to defer the gain by investing in an opportunity fund; perhaps time and responses will offer clarity.

Continued Qualification of Investment: The legislation enacted by Congress provides that an opportunity zone designation is only in effect for ten years. The regulations clarify that investors receive the benefit of the ten-year holding period even after the opportunity zone designation expires. In fact, investors may hold investments in opportunity funds until January 1, 2048, and receive all opportunity zone benefits.

Gains Eligible for Deferral: The proposed regulations clarify that only capital gains are eligible for deferral, even though the legislation refers to gain from the sale of any asset. The regulations also clarify that eligible gains include collectibles gain and unrecaptured Section 1250 gain on the sale of real estate. Finally, the regulations clarify that a taxpayer can split the gain from a single transaction into multiple opportunity fund investments.

Recognizing Gain: The proposed regulations provide that when the gain is recognized (either when the interest in the fund is sold or on December 31, 2026), the gain will have the same attribute as the deferred gain had in the year it was originally deferred. For example, if the deferred gain was a short-term capital gain, then the gain will be treated as a short-term capital gain when it is recognized. The regulations also explain that, if a taxpayer has made several investments in opportunity funds, the gains from future sales will be recognized on a FIFO basis.

Working Capital Safe Harbor: The proposed regulations provide a safe harbor for the 90% asset test. This safe harbor addresses concerns that acquisitions of opportunity zone property will not always occur when anticipated. The safe harbor provides that opportunity funds meet the 90% asset test if the opportunity zone business can demonstrate that the funds will be used to acquire opportunity zone property within 31 months.

Certifications of Opportunity Funds: The proposed regulations explain that opportunity funds can self-certify by filing an IRS Form 8996.

Deferral Election: The proposed regulations also state that taxpayers should attach Form 8949 to their federal income tax returns identifying the gain the taxpayer is electing to defer.

If you have any questions about investing in opportunity funds, please contact the authors of this article.