Background
Most taxpayers are aware of the lower tax rates and the new pass-through business deduction implemented by the Tax Cuts and Jobs Act of 2017 (the “Tax Act”). However, two less publicized sections, 1400Z-1 and 1400Z-2, added by the Tax Act provide taxpayers an opportunity to defer and even reduce taxes on the sale of property.
Under these sections, when a person sells or exchanges property, that person may defer paying taxes on any gain by reinvesting the proceeds in a “qualified opportunity fund” (a “Qualified Fund”). Generally, investing in a Qualified Fund allows a person to defer all or a portion of realized gain on the sale or exchange of property until December 31, 2026, or until the taxpayer sells his investment in the Qualified Fund, whichever is earlier.[1]
Moreover, people who invest in such funds can reduce their taxable gain by holding the investment for a specified period of time. If a person holds an investment in a Qualified Fund for at least five years, he will reduce his taxable gain by 10%[2], with an additional 5% being excluded if the investment is held in a Qualified Fund for at least seven years.[3]
In addition to the tax deferral and 15% gain reduction, a person who holds investments in a Qualified Fund for at least ten years receives the additional benefit of avoiding taxes from any appreciation in value upon the disposition of the Qualified Fund.[4]
Example
For example, suppose John buys property for $1,000. Later, he sells the property for $2,000, creating a taxable gain of $1,000 (the $2,000 sale less his $1,000 initial investment). Normally, John would owe taxes on that $1,000 of gain. However, if he invests the $1,000 of taxable gain into a Qualified Fund, he will defer paying taxes on the $1,000 until either December 31, 2026, or until he sells his investment in the Qualified Fund, whichever is earlier.
If John holds the investment for five years, his taxable gain is reduced by 10%, from $1,000 to $900. After holding the investment for seven years, John’s taxable gain is reduced by another 5% of the initial gain of $1,000, so that his taxable gain is now $850.
When December 31, 2026 arrives, John must pay taxes on the $850. However, if he continues to hold the investment in the Qualified Fund for ten years, John will not recognize any gain when he sells the investment. In other words, John is not taxed on any of the Qualified Fund’s appreciation from the past ten years.
What is a Qualified Fund?
So, what exactly is a Qualified Fund? Simply put, a Qualified Fund is a corporation or partnership (which includes LLCs) that holds at least 90% of its assets in “qualified opportunity zone property”.[5] Such property generally includes any real estate or tangible property that is located in a “qualified opportunity zone.” These zones are designated by a state’s governor, then submitted to the U.S. Treasury Department for approval.
[1] § 1400Z-2(b)(1).
[2] § 1400Z-2(b)(2)(B)(iii).
[3] Id. § -2(b)(2)(B)(iv).
[4] Id. § -2(c).
[5] Id. § -2(d)(1).
