Buried within the Tax Cuts and Jobs Act of 2017 is a little-known provision titled as “Special Rules for Capital Gains Invested in Opportunity Zones” and effectuated into law as 26 U.S.C. § 1400Z-2. The provision changes how capital gains may be reinvested in property. It also modifies the tax treatment of capital gains and the tax basis of the underlying investment. A taxpayer may be able to defer a taxable gain, receive an abatement on applicable capital gains taxes, and receive a step-up in basis of the increase of the fair market value of the capital gain if the taxpayer invests capital gains in a tangible property used in a trade or business located in an opportunity zone.
What the New Provision Does
There are three key benefits of the program:
- The taxpayer will immediately receive a deferral of the capital gain until the earlier of the sale date of the investment or 2026;
- The taxpayer will receive an abatement of the capital gain on the investment depending on how long the investment is held:
- an abatement of 10% if held for five years;
- an abatement of 15% if held for seven years;
- an abatement equal to the lesser of (i) 85% of the original capital gain; or (ii) the fair market value of the investment until 2026;
- The taxpayer will receive a step-up in basis in the investment to the fair market value on the date sold if the investment is held for ten years.
To illustrate, if a taxpayer realized a gain of $100,000 in 2018, he or she could reinvest that gain into an opportunity zone and defer the payment of taxes on that capital gain. If the taxpayer sold the property in 2023, he or she would pay tax on gains of only $90,000 notwithstanding the original $100,000 gain. If the investment is held until 2026, the taxpayer would pay tax on a capital gain of only $85,000 of the original $100,000 gain. Most importantly, if the taxpayer sold the property after ten years for $150,000, the basis in the property would be increased to $150,000, thus receiving essentially $50,000 of tax-free gain.
In order to be eligible for the provision, a taxpayer must reinvest a gain into a properly organized qualified opportunity fund within 180 days of the sale of property otherwise subject to a taxable gain. The fund must make invest in property located within a qualified opportunity zone.
There are a number of eligibility tests for how the fund is invested in and who can make the investment, but generally as long as the gain is invested in tangible property used in a trade or business located in the opportunity zone within the time constraints provided by the IRS and the Treasury Department, it will qualify for the tax provision.
Investment in existing buildings and construction of new facilities may also qualify under the new provision, though special consideration must be given to the timing of the investment and construction of the new facility.
Owners of property within an opportunity zone seeking to reinvest in their property are not necessarily disqualified, however special consideration needs to be given to structure their investment to ensure qualification under the provision.
Finally, investments in all tangible property, whether real estate, business equipment, or otherwise, are eligible for participation in the new tax provision.
The implications of opportunity zones for investment are broad and could present a boon to investors and developers alike. If you are considering investing in property, weigh whether this program may make your investment more economically favorable.
The opportunity zones in the State of Maine can be found at https://www.maine.gov/decd/news/news.shtml?id=797903.
One caution: The new tax provision is untested and complex. While this article is intended to convey generally understood implications of the provision, the Internal Revenue Service and the Treasury Department will undoubtedly provide guidance in the days ahead. Consult with an attorney before structuring an investment into a qualified opportunity zone to ensure that your investment is qualified.
David Johnson practices in the Real Estate and Business Practice Group. For further information, contact Attorney Johnson at 207-985-7000 or firstname.lastname@example.org.