What Capital Gains Tax?
How Investing in Low-Income Communities Can Earn You Tax Breaks (including Temporary Deferral, Stepped Up Basis, & Permanent Exclusion)
The Tax Cut and Jobs Act (TCJA) enacted in December of 2017 created a new Internal Revenue Code Section 1400Z-1, which designates certain low-income community population census tracts as qualified opportunity zones. A population census tract that is a low income community is designated as a qualified opportunity zone if the chief executive officer of the State in which the tract is located nominates the tract for designation as a qualified opportunity zone, notifies the IRS in writing of the nomination, and the IRS certifies the nomination. In an effort to spur investment and growth in distressed communities throughout the country, the TCJA allows investments in qualified opportunity zones to be eligible for favorable tax treatment.
Investing in an Qualified Opportunity Zone
In order to invest and qualify for favorable tax treatment, the investments have to be made through a qualified opportunity fund. A qualified opportunity fund is an investment vehicle, organized as a corporation or partnership, which holds at least 90% of its assets in qualified opportunity zone property. Qualified opportunity zone property includes any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.
US Map of Qualified Opportunity Zones by Census Tract
Temporary Deferral of Capital Gains Tax
Code Section 1400Z-2 allows for a temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund. The maximum amount of the deferred gain generated from the sale of any property (including stock) equals the amount invested in a qualified opportunity fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains. Note that Code Section 1400Z-2 provides a deferral if an amount equal to the “gain” is reinvested in a qualified opportunity zone fund. This requirement is not as burdensome as the investment required under Code Section 1031, Like Kind Exchanges. Code Section 1031 requires the full sales price to be reinvested in new property in order to receive a full deferral of the gain.
Example 1: On Dec. 1, 2021, T sells property for $6 million with a basis of $1 million and realizes a gain of $5 million. On Dec. 31, 2021 (within 180 days of sale date), T invests all of the $5 million in a qualified opportunity fund. If T makes the temporary deferral election, T does not include the $5 million of realized gain in his gross income for the 2021 tax year.
No election is allowed to be made if an election previously made with respect to a sale or exchange is already in effect and no election is allowed after December 31, 2026. Any gain deferred will be includible in income upon the earlier of either the date on which the investment in the qualified opportunity fund is sold or December 31, 2026.
Example 2: Same facts as example 1, except that T makes the temporary election to defer the $5 million gain and holds the investment in the qualified opportunity fund until Dec. 31, 2026, the last year of the election. T has to include the deferred gain (subject to modifications discussed below) in gross income in 2026 since it is the last year for which the election can be in effect.
The amount of the gain is the lesser of the amount of gain excluded or the fair market value of the investment (at the end of the deferral period i.e. Dec 31, 2026) over the basis in the investment. Except for increases to basis as discussed below, the taxpayer’s basis in the investment (post deferral election) is zero. In the case of any investment held for at least five years, the basis of the investment is increased by an amount equal to 10% of the amount of the gain temporarily deferred. In the case of any investment held for at least seven years, the basis of the investment is increased by an additional 5% of the amount of the gain temporarily deferred, thereby totaling 15% (10% + 5%).
Example 3: Same facts as example 1 and 2, except that the FMV of T’s investment is $7 million. Upon the end of the deferral period, Dec. 31, 2026, T will have a basis in the investment of $500,000 (10% of the $5 million deferred gain because he held the qualified investment for five years from 2021-2026). T will therefore have to include a gain of $4.5 million in his gross income in 2026 ($5 million of original gain less $500,000 of basis). The deferred gain is used in this example to calculate the includible gain because it is the lesser of the deferred gain and the FMV of the investment.
Example 4: Same facts as examples 1,2 and 3, except that the FMV of T’s investment is $4 million. Upon the end of the deferral period, Dec. 31, 2026, T will have a basis in the investment of $500,000 (10% of the $5 million deferred gain). T will therefore have to include a gain of $3.5 million in his gross income in 2026 ($4 million of FMV less $500,000 of basis). The FMV is used in this example to calculate the includible gain because it is the lesser of the deferred gain and the FMV of the investment.
Permanent Exclusion of Capital Gains Tax
A taxpayer holding a qualified opportunity zone investment for at least ten years may make a permanent exclusion election under Code Section 1400Z-2(c), which will treat the basis of the property as being equal to the fair market value of the investment on the date that the investment is sold or exchanged. Therefore, under the permanent exclusion, any post-acquisition capital gain on investments in qualified opportunity funds that are held at least ten years are excluded from gross income. It is important to keep in mind that the gain on the initial deferral would still be recognizable on December 31, 2026.
Example 5: Same facts as examples 1 thru 3, except that T has decided to hold his investment in the qualified opportunity fund for ten years until December 31, 2031 and sell it immediately thereafter for its FMV of $9 million. As in example 3, T would have recognized a $4.5 million gain in his gross income in 2026, the end of the temporary deferral period. On December 31, 2031, T makes the permanent exclusion election, by which his basis in the qualified opportunity property ($4.5 million) is stepped up to now equal its FMV of $9 million. Although T’s investment has had a post deferral period appreciation of $4.5 million ($9 million FMV less gain previously recognized of $4.5 million), T will not recognize any capital gain on the post deferral period appreciation ($9 million FMV less $9million of stepped up basis).
Contact An Advisor
The TCJA has evidently provided taxpayers with potentially lucrative tax savings through the qualified opportunity zones. With proper planning, taxpayers can reduce their tax liability while at the same time investing in the development of distressed communities. If you have any interest or questions about investing in qualified opportunity zones, please contact a trusted tax advisor.