With summer upon us and the fall soon approaching, it may be worthwhile to consider opportunity zone investments to defer capital gains expected to be recognized during 2022 (as well as 2021 in certain circumstances). The ability to utilize qualified opportunity zone funds (QOFs) to defer income taxes in the short-term, and permanently avoid taxation of future appreciation, can significantly enhance long-term investment returns.
Recently, a bipartisan bill was introduced by Senators Cory Booker (D-NJ) and Tim Scott (R-SC), along with Representatives Ron Kind (D-WI) and Mike Kelly (R-PA) intended to both reform and extend the benefits of the opportunity zone program.
The following are the highlights of the legislation as proposed:
- The deferral period of tax on capital gains invested in either new or pre-existing QOFs would be extended until December 31, 2028 (as opposed to December 31, 2026, under existing law).
- Investments into QOFs made by December 31, 2023, would qualify for the 10% basis increase/reduction of deferred gain to be recognized on December 31, 2028 (this previously only applied to pre-12/31/21 investments).
- Investments into QOFs made by December 31, 2022, and held until December 31, 2028, would qualify for an additional 5% basis increase (15% in total when combined with the above) and a reduction of the deferred gain recognized on December 31, 2028. (This is effectively a shortening of the current required seven-year hold to six years to achieve the 5% basis increase).
- Allows for the formation of US partnerships that can elect to be QOF feeder funds, with the primary benefit of being able to invest in other QOFs (prohibited under current law).
- Expansion of existing reporting requirements. This includes the reporting of additional information about investors in the QOFs and the qualified opportunity zone businesses (QOZBs) in which they have invested. Penalties would be assessed for failing to report the information. The Department of the Treasury expects to publish an annual report on national activity that will include data focused on the number and make-up of QOFs.
- Sunsetting (i.e., disqualification) of the Opportunity Zone designation for any tracts with a median family income (MFI) at, or over, 130% of the national MFI. States will also be granted flexibility to sunset additional zones and will also be allowed to replace disqualified tracts with new low-income zones while existing investments will be grandfathered.
The proposed legislation is subject to change prior to enactment.
Irrespective of the proposed legislation being enacted, opportunity zone investment remains a viable technique for reducing tax burden and increasing investment return. As a particular example, QOFs invested in real property developments can provide all the benefits of QOF investing, and potentially provide an additional opportunity to deduct annual operating losses. Utilizing a cost segregation study, which aims to properly classify development or acquisition costs for purposes of claiming tax depreciation, can further enhance the benefits of QOF investments. In many instances, cost segregation studies result in significantly accelerated depreciation deductions.
Under the favorable provision that qualified replacement property held for 10 years receives a 100% exclusion of post-replacement appreciation, on exit, any “recapture” income associated with the depreciation would not be recognized, assuming the QOF ten-year holding period requirement is met. Be advised the 100% federal bonus depreciation is set to decrease to 80% starting January 1, 2023, providing incentive to place property in service before year-end 2022.
Since the equity attributable to the original gain invested in a QOF has no tax basis, project debt would typically need to be utilized to provide basis to deduct any losses. Also, such losses may be subject to other limitations such as the federal tax passive activity loss limitations.
There is still time to defer 2021 Gains
Keep in mind that September 11, 2022 is the deadline for opportunity zone funding on capital gains recognized during 2021 through a Schedule K-1 received from a pass-through entity. For many tax returns on extension having K-1 gains coming through for 2021, this is a benefit that could help reduce 2021 taxes. While those invested gains will not currently qualify for the 10% or 5% basis increase under current law, they will be eligible for all other QOF benefits.
Finally, not all states are in conformity with the federal tax treatment of opportunity zone investing. The tax treatment may be dependent on both the source of the capital gain and your state of tax residency.