By Blake Christian
One of the most powerful federal tax provisions in decades became law in 2018, yet the vast majority of the investor and business world has only recently become aware of the full potential of the Opportunity Zone (OZ) program.
The OZ program has wide application and benefits to participants similar to Internal Revenue Code (IRC) Section 1031/ “Like Kind Exchanges” tax deferral, as well as permanent tax-free build up for a portion of future gains, similar to Roth IRAs.
The majority of information in the press has focused on the OZ program’s benefits for real estate developers; however, the program also lends itself to investors and serial entrepreneurs who start-up or expand businesses in one of the approximate 8,700 eligible Opportunity Zones.
One of the least talked about aspects of the program is how OZ program participants will be impacted at the state level. Since only 31 states have opted to conform to the federal rules, there are a myriad of issues which need to be evaluated before opting into the OZ program and making specific investments from a Qualified Opportunity Fund (QOF).
How should investors evaluate the program’s from both a federal and state perspective?
The Federal Opportunity Zone Program
The Tax Cut and Jobs Act of 2017 created the QOZ effective in January 1, 2018 and operative for up to the next four decades.
The architects of the program are a trio including Silicon Valley tech guru Sean Parker, Senator Corey Booker (D-NY) and Senator Tim Scott (R-SC). Parker recognized that there is a massive concentration of trapped tax gains in IPO stocks, real estate and other assets. The Senators liked the program’s focus on attracting investment into under-served neighborhoods.
The QOZ program offers eligible taxpayers the ability to defer their original capital gain for up to eight years, eliminate a portion of that gain after holding the QOF at least 5 years, and then after a 10-year hold, eliminating any post-reinvestment federal (and possibly state) gain which accrues after the original reinvestment. To participate, taxpayers must roll all or a portion of their short-term or long-term capital gain into a QOF. The QOF must then timely, in a 180-day window, invest the gain into undeveloped or developed real estate, a new or existing QOZ-based operating business, or into other qualified QOZ property located in one of the 8,700 designated census tracts.
QOZ Program – Phase I – The 180 Day Gain Re-Investment Period
Beginning Jan. 1, 2018 through Dec. 31, 2026, individuals, corporations, REITs, and pass-thru entities can invest gains realized from their appreciated capital assets and elect to reinvest all or a portion of the resulting capital gain into a QOF. The initial federal tax impact of participating in a QOF includes deferring qualified gains until Dec. 31, 2026.
The taxpayer has up to 180 days (including the date of sale – this is different than six months) to reinvest all or a portion of the capital gain portion of their gain transaction. The proposed regulations provide some useful guidance on re-investment timing. Gains flowing through entities such as partnerships, S Corps, Trusts and REITS are deemed to occur on the last day of the year.
The QOF then has up to six months to move the funds into an operating entity or other Qualified Opportunity Zone Property (OZ Property). To the extent the investment involves the improvement of tangible property, the taxpayers have up to 31 months to invest adequate funds into the OZ Property.
Phase II – Five Year Tax Basis Step-Up
The QOF investors start off with a $0 tax basis in the Fund, since the gain is being deferred until 2026. However, after holding the QOF for five years, the program allows the taxpayer to “step-up” or increase the tax basis in their investment by 10 percent. Therefore, a taxpayer with a $1 million deferred gain invested in a QOF will increase their tax basis from $0 to $100,000 after five years.
Phase III – Seven Year Step-Up
After a seven-year hold, the taxpayer is entitled to a secondary step-up of five percent, so in the seventh year the taxpayer in the above example would receive a $50,000 step-up taking the total tax basis to $150,000. At this point, a sale before Dec. 31, 2026 would yield an $850,000 gain, rather than the full $1 million gain that was deferred.
Phase IV – Dec. 31, 2026 Deferred Gain Recognition
Assuming the QOF has not yet been sold by the end of 2026, the investor will be required to pick up the remaining deferred gain of $850,000 ($1 million - $150,000 basis step-ups from years five and seven). At this point, the investor’s tax basis in the QOF has increased to the full $1 million deferred gain. A sale of the Fund at this point would yield a federal tax gain equal to the difference between the sales prices and the $1 million tax basis. Therefore, 15 percent of the tax gain ($150,000) will permanently escape federal taxation. If the taxpayer holds the QOF through 2029 or longer (10-year hold), they can also exclude from income tax the appreciated value of the Fund (the tax basis steps up to fair market value at year ten or more when sold).
State Tax Rules – A Minefield for Investors
State conformity to this program is varied and requires a very careful state-by-state analysis.
Even though every state has qualified OZ census tracts, the OZ program is a federal statute and state conformity is in the hands of the state legislators. To date, only 31 states and the District of Columbia have elected to conform to the federal program.
While the federal program offers tax planning opportunities, the state ramifications can be a minefield for the uninformed. When choosing an investment state, tax planning is imperative. Since only 31 states have fully embraced the program, taxpayers may still incur a tax liability in their home state, and potentially other states if the QOF makes multi-state investments. As a result, taxpayers considering making a QOF investment should have a CPA or attorney who is very familiar with the tax aspects of the program thoroughly review the investment prospectus.
Opportunity Zone State Level Treatment
Assume a New York resident (a conforming QOZ state) reinvests a $1 million gain from the sale of a New York asset in 2018 into a 2019 QOF that then invests into a California (a non-conforming state that may allow limited OZ projects) real estate project. Further, assume that the QOF subsequently appreciates to $1.7 million in year 10, the year of sale of the QOF investment.
Due to New York’s QOZ conformity, tax on the original $1 million gain will be deferred for federal and New York tax purposes. In 2029, (the 10-year milestone) the basis of the QOF investment will have been adjusted to fair market value resulting in no reportable gain on the subsequent sale of the QOF investment for federal and New York purposes. For California purposes, since California will generally only conform to the OZ program for certain affordable housing, senior living and selected “green” projects, the tax basis in the QOF will start out at the full $1 million invested. However, no California basis adjustments will occur in years five, seven, and 10. Also, no deferred gain will be reportable in California in 2026. Upon disposition of the QOF; however, the $700,000 gain ($1,7 million less $1 million basis) will be fully reportable in California.
Due to the potential additional state-level taxes that individuals, estates, trusts, and business taxpayers might incur as a result of residing or investing into a state that has not adopted the OZ program at the state level, taxpayers will need to fully evaluate the future federal and state tax exposures from such investments. Limiting QOZ investments to an investor’s home state, other OZ conforming states or states that have no state income tax is generally recommended.
For real estate projects in states that have not adopted the OZ program, and especially in higher-rate states (such as California), an IRC Section 1031 “Like-Kind Exchanges” should generally be considered over a QOF if the asset being disposed of is primarily real estate. To the extent the taxpayer cannot meet the Like Kind Exchange 180-day reinvestment period, the OZ program can offer a potential safety valve for federal purposes by timely rolling the un-reinvested funds into a QOF, which can give the taxpayer more time to reinvest.
Due to the varying state OZ conformity and other tax complexities asso