Borderland Tax Tips: Issue #1: Last Chance for Maximum Opportunity Zone Benefits
By David S. Hansen
On December 22, 2017, The Tax Cuts and Jobs Act of 2017 (the “TCJA”) was passed into law in an atmosphere of bitter partisanship. So bitter in fact, that Democrats successfully initiated a maneuver to change the official name of the TCJA to “The Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”
For brevity sake, we will continue to use the more commonly accepted name of TCJA. However, the long form name referring to “reconciliation” is important to note because it alludes to some quirky aspects of the law that not many people are aware about, and which impact that newly created “opportunity zones.”
Under the procedural rules of the Senate, no law passed by reconciliation (a procedure allowing a bare majority of votes to pass a law) can increase the deficit after a decade. To avoid increasing the deficit after 10 years, the TCJA makes some tax cuts (mostly on corporations) permanent, temporarily lowers other taxes (mostly on politically popular groups like individuals) for ten years, and permanently eliminates certain deductions (effectively raising taxes) on corporations and individuals. In other words, after ten years, the temporary cuts expire, and the permanent cuts are offset by permanent increases, netting to zero.
Republicans anticipated that after the reconciliation it would be an easy political case to make the temporary tax cuts on politically favorable groups permanent and restore some of the more popular deductions under a regular-order bill (not subject to the deficit restrictions) that could win enough support to overcome a filibuster (60 votes). However, the public soured on the tax cuts and the 2018 elections resulted in divided government and an even more partisan atmosphere. In such an atmosphere it may well be that the temporary tax cuts will not be made permanent.
One of the temporary tax cuts created an incentive for investment in “opportunity zones.”1 The rules of opportunity zones are complex, however, they create powerful tax incentives to invest in impoverished areas labeled “opportunity zones.” Many of such zones are in El Paso County, Texas and Doña Ana County, New Mexico. The specific opportunity zones can be identified on a map published by the US Department of Treasury Community Development Financial Institutions Fund here.
The tax incentive is triggered where (1) a taxpayer sells a capital asset at a gain and (2) within 180 days of the gain triggering event, invests the proceeds in a “qualified opportunity fund.” Assuming the qualified opportunity zone fund properly invests the gains in a qualified opportunity zone and follows a number of other technicalities, the following three benefits are gained:
- Gain Deferral – Tax on the gain is deferred until the earlier of the investment being sold/exchanged or December 31, 2026.2
- Partial Forgiveness of Original Gain – If the investment is held for at least five years, 10% of the gain is effectively forgiven (basis in the investment increases 10%).3 If the investment is held for at least seven years, an additional 5% of the gain is effectively forgiven (basis increased to 15%)4 (“5 Year Benefit” and “7 Year Benefit” respectively)
- Total Forgiveness of Appreciation in Investment (“10 Year Benefit”) – If the investment is held for at least ten years, in addition to 15% of the original gain being forgiven, all of the gain from the appreciation of the opportunity zone investment is eliminated (basis increased to FMV of the appreciation in value).5
Additionally, it is worth noting that unlike a 1031 exchange, you only need to invest the “gain” itself, not the cost basis of your original investment. Indeed, that gain is the only portion of the investment that gains a tax benefit. This is an advantage because you can both “cash out” to the extent of basis in your original investment AND defer the gain.6
To illustrate is the following example: On January 1, 2018, Person A sells capital property he had held for many years for a gain of $1,000,000 (the “Original Proceeds”). He invests the gains on the same day in a qualified opportunity fund (within 180 days) to invest in an opportunity zone.
If Person A, did not invest in the opportunity fund, he would recognize $1,000,000 of gain on the Original Proceeds and pay up to $238,000 in taxes (23.8% maximum long term capital gain rate7) (the “Original Capital Gain Tax”). However, since he invested in the opportunity fund, he pays no taxes on the gains in 2018 . His gains are deferred. The Chart below shows the value of Person A’s investment after tax at five, seven, and ten year liquidation horizons assuming 5% growth on the investment:
1. Opportunity zones and their operation are described in Internal Revenue Code (“IRC”) 1400Z-1 and 1400Z-2.
2. IRC 1400Z-2(b)(1)
3. IRC 1400Z-2(b)(2)(B)
5. IRC 1400Z-2(c)
6. See IRC 1400Z-2(a) and (b).
7. Note: IRC 1400Z-1 and 2 do not specify that the eligible capital gain must be long term capital gain. The tax benefits are even greater when you can defer and forgive short term capital gain that would otherwise be taxed as ordinary income.
|Invests in Opportunity Zone||Invests Outside of Opportunity Zone||Benefit from Use of Opportunity Zone|
|January 1, 2018||$1,000,000 = Investment (note: if sold immediately, worth $761,000.00)||$762,000 = Original Proceeds – Original Capital Gain Tax = “Non-O Investment”||N/A = Same if opportunity fund sold immediately|
|January 1, 2023
|$996,326 = (Investment grown at 5% annually = $1,276,282) – 90% of Original Capital Gain Tax – 23.8% of Investment appreciation (= 23.8% x ($1,276,282 – $1,000,000))||$922,421 = (Non-O Investment grown at 5% = $972,527) – 23.8% of Non-O Investment appreciation (= 23.8% x ($972,527 – $762,000))||$73,905|
|January 1, 2025
|$1,107,911 = (Investment grown at 5% annually = $1,407,100) – 85% of Original Capital Gain Tax – 23.8% of Investment appreciation (= 23.8% x ($1,407,100 – $1,000,000))||$998,380 = (Non-O Investment grown at 5% = $1,072,211) – 23.8% of Non-O Investment appreciation (= 23.8% x ($1,072,211 – $762,000))||$109,530|
|January 1, 2028
|$1,416,480 = (Investment grown at 5% annually) – 85% of Original Capital Gain Tax recognized at the end of 2026 – Nothing||$1,127,164 = (Non-O Investment grown at 5% = $1,241,218) – 23.8% of Non-O Investment appreciation (= 23.8% x ($1,241,218 – $762,000))||$289,316|
As can be seen from the above chart, the opportunity zone investments can result in some significant tax advantages, with greater advantage being gained the longer the investment is held.
The Flaws Including the Secret 2019 Deadline:
The most obvious and significant flaw in the opportunity zone structure is the expiration of the opportunity zones at the end of the 10th calendar year after designation pursuant to IRC 1400Z-1(f). Had that not been addressed by proposed regulations, the largest benefit of the opportunity zones would have been lost if investments were not made on or before December 31, 2018 (the date ten years prior to the expiration of the opportunity zones).
Fortunately, Proposed Treasury Regulation 1.1400Z-2(c)-1(b) corrects that problem by stating that:
The ability to make an election under section 1400Z-2(c) for investments held for at least 10 years is not impaired solely because, under section 1400Z 1(f), the designation of one or more qualified opportunity zones ceases to be in effect. The preceding sentence does not apply to elections under section 1400Z-2(c) that are related to dispositions occurring after December 31, 2047.
Thus, you can still qualify for the 10 year benefits so long as you invest gains in an opportunity fund before January 1, 2027 and sell the investment after 10 years on or before December 31, 2047.
However, the 5 year and 7 year benefits are NOT given any special treatment in the proposed regs. IRC 1400Z-2(b)(1)(B) causes recognition of the deferred original gain at the latest on December 31, 2026. If it has not been five or seven years respectively by the time December 31, 2026 comes along, you will not have a 10%/15% stepped up basis at the time of that recognition event.
If you continue to hold the investment you will eventually receive a basis step-up of 10/15% for 5/7 years of holding respectively, but you will only recognize a benefit when you sell the investment. You therefore lose the time value of money from the taxes on that 10/15% of the original gain if you delay. You also shorten the window of deferring gain on the entire original gain the close you are to December 31, 2016. The combination of those effects can be significant.
Accordingly, the only way to gain the full 7 Year Benefit with a 15% basis step-up on invested gain is to invest in an opportunity fund on or before December 31, 2019.
The only way to gain the full 5 Year Benefit with a 10% basis step-up on invested gain is to invest in an opportunity fund on or before December 31, 2021.
It is also critically important to note that the last date to take advantage of the 10 Year Benefit is on or before December 31, 2026 and if you delay past that date you cannot take advantage of the 5 or 7 year Benefits either. This is significantly shorter than the December 31, 2028 date that the opportunity zone designations expire or the December 31, 2047 date to sell an investment provided in the proposed regulations.
These deadlines have significant tax consequences on the overall investment that are compounded by the potential loss of deferral as illustrated in the following chart depicting net proceeds after ten years if investments (assuming 5% annual growth) are made on January 1, 2019 vs. 2020, vs. 2022, vs. 2027.
|Proceeds After 10 Year Liquidation:||$1,310,076.18||$1,302,831.55||$1,283,806.67||$1,128,122.33|
|Cost of Delay:||-$7,244.63||-$26,269.52||-$181,953.85|
As can been seen, a delay of even less than one year to 2020 will result in significant losses of tax benefits compared to an investment in 2019. If you intend to take advantage of the opportunity zones, you have a limited window of time in which to take advantage.
If you have property with significant gains that you are considering selling, you may want to consult with your tax adviser to see whether opportunity zones would be an ideal investment for you.