New Tax Law with Great Opportunities
Many CPAs are familiar with the more well-known and established sections of the tax code such as Sections 179 and 1031. Section 1400Z — special rules for capital gains invested in Qualified Opportunity Zones (QOZ) — which was introduced by the Tax Cuts and Jobs Act of 2017 could soon join those ranks. Section 1400Z offers both gain deferral and gain exclusion in exchange for investment in a low-income community or Opportunity Zone (OZ).
If a taxpayer invests capital gains in an OZ fund, the resulting deferred capital gains, if held a minimum of five years, are given a 10-percent reduction in the amount taxed. If held for seven years, they receive an additional 5-percent tax reduction for a total of 15 percent.
The temporary deferral of capital gains taxes on deferred gains invested in an OZ fund lasts until the taxpayer exits the OZ fund or Dec. 31, 2026, whichever occurs first. If a taxpayer holds the investment for 10 years, the new capital gains accrued in the OZ fund will receive a full step-up in basis after the 10-year period. A taxpayer may make an election to treat the basis on the date of sale as the fair market value of the qualified opportunity fund (QOF).
Similar to a 1031 exchange, the taxpayer has 180 days beginning on the date of the sale to invest the capital gains from the sale of property with an unrelated person in a QOF. If the capital gain is through a partnership, then it is either 180 days from year-end or the partner may choose the date of the sale.
Consider this example: On Feb. 1, 2019, a taxpayer sold Amazon stock for $1.1M with a cost basis of $100,000. The taxpayer then invests the $1M gain into a QOF and sells the entire investment in 2033 for $3M. The Taxpayer recognizes phantom income on Dec. 31, 2026, of $850,000 (1M * (1-.15)) and recognizes no gain in 2033 on the additional $2M gain ($3M - $1M). To receive the 100-percent exclusion ($2M), the taxpayer must sell before Dec. 31, 2047.
The New Jersey Division of Taxation has provided notice that New Jersey will follow the federal QOZ rules. New York also allows the QOZ benefits. If the taxpayer is a New Jersey resident and would like to keep the capital gains in New Jersey, the following website lists the designated opportunity zones: nj.gov/governor/njopportunityzones.
The election to defer eligible gain is made on Form 8949, sales and other dispositions of capital assets.
If a taxpayer makes the initial QOF investment in 2022 or later, then by the time of the five-year anniversary, it will be beyond 2026 and all the gain will have been recognized.
Similar to an investment in a partnership, Section 1231 gains and losses must be netted at the end of the tax year so the 180-day period for a Section 1231 gain being invested in an OZ fund may begin on the last day of the taxable year.
Let’s briefly compare QOF to a 1031 exchange:
- With a 1031 exchange, as of Jan. 1, 2018, only real property qualifies, the entire proceeds from the sale (net equity plus debt replacement) needs to be reinvested and tax deferral can be farther out than Dec. 31, 2026.
- With a QOF, any property that generates capital gain qualifies, only the capital gain may be reinvested and obtain QOF treatment (although not all of the gain needs to be reinvested) and tax deferral ends on Dec. 31, 2026.
Keep in mind any capital loss carryforwards and NOLs when advising whether a QOF makes sense. In addition, if the investment in the QOF decreases, the potential tax savings can be lost.
Revisiting the above example, if a taxpayer does not know about this potential tax savings opportunity and provides their tax documents in March of 2020, due to the 180-day rule, Section 1400Z would be a moot point.
Advising taxpayers to review their investment portfolio for unrealized gains to be realized can also be advantageous. CPAs should take action now to inform clients of this tax opportunity.
This article appeared in the January/February 2020 issue of New Jersey CPA magazine. Read the full issue.