By: Kenneth C. Foltz, Sr., Esq.
The Opportunity Zone program, created in the Tax Cuts and Jobs Act of 2017, encourages long-term investments in designated economically distressed communities by providing tax incentives to the investor. The potential tax benefits for investing in an Opportunity Zone property or company include temporary tax deferrals, reduction in capital gains, or forgiveness of capital gains. The Opportunity Zone Program may also be beneficial to individuals or companies that have experienced, or will be experiencing, capital gains, for which they would like to reinvest those gains to defer paying the taxes on those gains and potentially obtain a reduction in the taxes owed.
Please click here for the areas designated as Opportunity Zones in Pennsylvania. Readers can also search nationally to determine if a property or community is eligible as an Opportunity Zone.
Benefits of the Opportunity Zone Program
The Opportunity Zone program provides three basic tax benefits for investing in an Opportunity Zone property or company:
|Temporary tax deferral on any capital gains reinvested in a qualified opportunity fund (“QOF”) or qualified opportunity zone business (“QOZB”) within 180 days of sale that creates a capital gain event. Capital Gains Taxes will be deferred until the later of (i) date the QOF/QOZB investment is sold or exchanged; or (ii) until December 31st, 2026 (*provided there are discussions that this date may be pushed out further).|
|If an investment is held in a QOF/QOZB for a period of 5 years – the taxpayer will receive 10% step-up in basis on the original capital gain. An additional 5% step up in basis for investments that are held for 7 years in a QOF/QOZB, but unless the December 2026 payment date noted above is extended – the 7-year hold period cannot be reached to obtain the additional reduction.|
|The last and potentially most significant benefit of the program is if the investor keeps their investment in the QOF/QOZB for a period of 10 years – they will get a 100% step up in basis to the fair market value of the QOF – which creates a 100% forgiveness of any gain on the QOF investment for said 10 year period. Note – this is not a forgiveness of the original capital gain that would need to be paid on December 31, 2026.|
How the Opportunity Zone Program Works
The following is an illustration of how the Opportunity Zone program works and the investor’s potential tax benefit in the program:
|An investor incurs a capital gain realization event of $1 million dollars on December 31, 2019. At the time of the event, the capital gain would result in a tax of $200,000, using a capital gains tax rate of 20%. However, on June 28, 2020, the $1 million dollars is invested into a QOF/QOZB. By doing so, the investor has elected to defer the tax on their capital gain until the earlier of (i) the sale of the QOF/QOZB investment; or (ii) December 31, 2026.|
5-Year Holding Period
|If the investor holds onto the QOF/QOZB investment until June 28, 2025 (five years), then their basis in the QOF/QOZB is increased 10% of the amount of the deferred original gain. Therefore, if the investor sold at this point, the capital gains taxable is $900,000, and the investor would pay $180,000 in capital gains tax on the original deferred amount – a savings of roughly $20,000.|
December 31, 2026
|At this time, the regulations have not extended the deferment period beyond December 31, 2026. Therefore, the investor cannot obtain the additional 5% basis adjustment for 7-year holding periods. Therefore, on the investor’s 2026 federal income tax return, the investor would need to report their capital gains and incur the $214,200 tax.|
10-Year Holding Period
|If after paying the tax on the original investment amount, the investor holds their QOF/QOZB investment until June 28, 2030 (ten years), then their basis in the QOF/QOZB investment will be a 100% step-up in basis to the fair market value of the investment. In other words, if the investor sells their QOF/QOZB investment for $3 million dollars, the investor will not recognize any additional capital gains tax. Thus, the investor would legally avoid capital gains taxes on $2 million, or $400,000 in capital gains tax.
Thus, the total tax benefits in this scenario would be a tax savings of $420,000 plus the six-year deferral on the original gain until December 31, 2026.
Similarly, if the investor continues to hold onto the QOF/QOZB investment beyond 10 years, any additional appreciation will continue to grow tax-free.
Below are some additional key pieces of information on the program:
- Who can use the program: Any corporation or individual can participate in the program. Commonly these will be entities or individuals with large capital gains to defer but having a capital gain is not a requirement to obtain the potential 10 year 100% step up benefit.
- QOF/QOZB structure: The QOF entity can be a corporation, limited partnership or LLC (if taxed as a Corporation or Partnership).
- Real Estate Investments: Many QOF/QOZB’s are being formed to invest in real estate projects located in Opportunity Zones; however, note that the QOF/QOZB investing must substantially improve the property to qualify. There are also some unique requirements and/or prohibitions in the Opportunity Zone regulations – for example, Triple Net Lease structures will not qualify.
- Company Investments: A QOF can make an investment directly into companies that operate or are located within an Opportunity Zone. There are significant rules and regulations regarding the business (operations, employment, etc.) that make this type of investment materially more complicated than real estate investments.
- Large QOF Investments: There are companies and non-profit organizations forming large investment funds as QOFs that will be looking to invest large sums of money in the near future. A leading accounting firm in the tax credit and Opportunity Zone program space, Novogradac, has reported that QOFs have raised over $7 billion.
If you have any questions about the Federal Opportunity Zone program, please contact Kenneth C. Foltz, Sr. Ken is a Partner with Leech Tishman and is based in the firm’s Pittsburgh, PA office. He is a member of the Real Estate, Corporate, Construction and Oil and Gas Practice Groups, as well as Co-Chair of the Energy Practice Group and the Cannabis Practice Group. Ken can be reached at (412) 417-9344 or firstname.lastname@example.org.
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Leech Tishman Fuscaldo & Lampl is a full-service law firm dedicated to assisting individuals, businesses, and institutions. Leech Tishman offers legal services in alternative dispute resolution, bankruptcy & creditors’ rights, construction, corporate, employee benefits, employment, energy, estates & trusts, family law, government relations, immigration, insurance coverage & corporate risk mitigation, intellectual property, international legal matters, litigation, real estate, and taxation. Headquartered in Pittsburgh, PA, Leech Tishman also has offices in Chicago, Los Angeles, New York, Sarasota and Wilmington, DE.