The Joe Biden administration seems resolutely committed to boosting U.S. tax rates, including income and capital gains tax rates. So the question of the hour is “What should taxpayers do about that? And when?”
As I suggested in the September 2021 issue of Financial Advisor, a prudent answer to “what” is to move your personal investment assets into a tax-free world and the prudent answer to “when” is, oh, anytime this afternoon—unless you can get it done this morning.
We’re following up on that article by going into the Land of “OZ”—or “opportunity zones,” the exciting tax incentives that were added to the Internal Revenue Code by the Tax Cuts and Jobs Act of 2017 and immediately became part of the American tax vernacular.
Opportunity zones allow U.S. investors to “do well by doing good”—specifically by investing recognized capital gains in designated low-income census tracts, or “qualified opportunity zones,” selected by the governor of each state according to the needs of those areas for capital investment and related business and social development.
Opportunity zone tax provisions have all kinds of unusual, complicated, peculiar and sometimes even hokey compliance requirements, starting with the fact that a taxpayer must recognize “capital gain” (or its Irish twin, a Section 1231 gain) and then must invest this into a “qualified opportunity fund” within 180 days of recognition (although there are multiple ways to count to 180 in the Land of OZ, where nothing is quite what it seems). The qualified opportunity fund, in turn, must invest in a business conducted in a qualified opportunity zone, either directly or through an investment of cash for newly issued equity in a business entity (a corporation or partnership) that then operates a qualified opportunity zone business.
The OZ Tax Benefits
Taxpayers who take advantage of the incentive by making a timely eligible investment into a qualified opportunity fund get three specific tax benefits (so long as they successfully invest capital gains recognized in 2021 into the fund by the end of the year) and the fund, in turn, then timely invests directly or indirectly in an eligible qualified opportunity zone business conducting activities in any qualified zone.
There are three opportunity zone tax incentives:
• The first incentive is deferral. Any recognized capital gain (or Section 1231 gain) invested in a timely manner into a qualified opportunity fund has the applicable taxation event deferred until the earlier of two dates: by the date that the taxpayer sells or otherwise terminates the interest in the fund (in what’s called an “inclusion event”) or by December 31, 2026, whichever comes first.
• The second incentive is a tax-basis adjustment. If the taxpayer invests in a qualified opportunity fund for at least five years, the outside tax basis increases by 10% of the original gain—and the added basis reduces the gain recognized when the deferral ends. (The original bill said there could be an additional 5% increase in basis if the investment lasted for at least seven years, but that was no longer possible by 2021.) A person’s ability to invest for at least five years before December 31, 2026, will expire at the end of 2021, which is why now—or at least until the end of 2021—is a pretty time-sensitive target date. Keep in mind, a taxpayer may still invest in a qualified opportunity fund and receive the two other incentives if he or she misses this end of 2021 date.
• The third incentive is exclusion from tax on all appreciation in the investment. If a taxpayer’s investment in the qualified opportunity fund is held for at least 10 years, the tax basis in the fund is increased to the fair market value of the fund on the date of sale. Thus, all gain on the investment (i.e., the appreciation in the investment, which is distinct from the deferred gain under the first incentive) is completely eliminated. In effect, it turns the exit strategy into a tax-free transaction.