Opportunity Zones: Tax Deferral and Exclusion Beyond Like-Kind Exchanges

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On December 22, 2017, the federal government enacted new legislation regarding investments in opportunity zones. Virginia designated 212 of these zones, and the federal government certified all of them. Like everything in the Internal Revenue Code, these provisions are complex. Moreover, desperately needed guidance has been sporadic. The incentives created for investing in opportunity zones are nothing short of incredible, however.

Many people have focused on the commercial real estate aspects of this new incentive, but the provisions are not limited to gains from real estate. Any gain (whether short-term or long-term) from a sale to an unrelated party can qualify for tax deferral or exclusion. Thus, a taxpayer can apparently reinvest his gain from the sale of stocks, bonds, or commercial or investment real estate, and if the gain is capital, utilize these provisions.

In addition, while a like-kind exchange requires a taxpayer to reinvest his tax basis first before he is granted any deferral, opportunity zone reinvestment only requires the gain to be reinvested. For example, assume that the taxpayer sells a property for $1 million in net proceeds with the tax basis of $600,000. To achieve full deferral in a like-kind exchange, the taxpayer has to invest in a property of $1 million or more. With opportunity zone deferral, that taxpayer only need invest his $400,000 in gain. The taxpayer can do as he pleases with the proceeds related to his $600,000 in tax basis.

Basically, the gain must be reinvested in a qualified opportunity zone fund (the "Fund") within 180 days of the sale (although gain passed through to a tax partner may qualify for an extended reinvestment period). The Fund must make qualifying investments in the zone but they may be in certain businesses conducted in the zone rather than just investing in real estate within the zone. If the requirements are met, the taxpayer does not recognize gain at the time of the sale. He must recognize the gain on the earlier of his sale of interest in the Fund or December 31, 2026.

This initial deferral is by no means the only incentive. The rules grant the taxpayer a step up in basis equal to: (i) 10% of the gain deferred when the Fund investment has been held five years and (ii) an additional 5% of the gain deferred when the fund investment has been held seven years.

Returning to our example, assume that the taxpayer invested his $400,000 in gain into a Fund on December 1, 2018. On November 30, 2023, the taxpayer would have a $40,000 increase in his tax basis. On November 30, 2025, the taxpayer would have an additional increase of $20,000. Therefore, even if the tax basis were not increased by other factors (an unlikely assumption), the taxpayer would only have to recognize $340,000 of gain on December 31, 2026 if he still held the investment. The taxpayer would have deferred his entire gain for eight years and one month and avoided 15% of the gain.

For the extremely long-term investor, the rules have an even better result. If the investment in the Fund is held for 10 years or more, upon election, the investor gets full exclusion of the gain when he sells it. In our example, assume that the taxpayer sells his investment in the fund on December 2, 2028 for $2 million. The taxpayer receives the entire $2 million without any federal income tax. In the alternative, assume that the taxpayer waits an additional two years and sells the investment for $4 million. He receives the entire $4 million without any federal income tax.

Obviously, these new provisions are very powerful. A taxpayer with a significant gain that is willing to take the risk of investing in an opportunity zone has compelling reasons to do so. As noted, very little guidance has come from the IRS regarding these provisions. Future guidance (or future law) may materially alter my conclusions. Any taxpayer needs to consult with, and rely upon, a competent tax advisor.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.