The 2016 Tax Cut and Jobs Act introduced a new
provision to the Code - the qualified opportunity zone – sometimes called an
“OZ.” I suspect that there was some humor while drafting the legislation, as
here is the Code section:
26 U.S. Code § 1400Z-1 –
Designation
(a) Qualified opportunity zone defined
For the
purposes of this subchapter, the term “qualified opportunity zone” means a population census tract that is a low-income community that is designated as a qualified opportunity zone.
Yep: 140 OZ.
There are different technical terms in this area; For example, “QOZ business property” would include tangible business property; “QOZ business” would include an active trade or business where substantially all of the tangible property is QOZ business property; and “QOZ Fund” would be an investment vehicle – can be a corporation but usually a partnership – used to pool funds for investment in OZs.
For this post we will use the generic term “OZ.”
BTW, if you are presently in an OZ, there is a tax event in 2026 that you must be aware of. We will discuss the issue below.
Let’s discuss the following topics:
(1) What are OZs?
(2)
Pre-2027 OZs
(3)
Post-2026 OZs
(4)
Gains reported through Schedule K-1
(5)
Another tax form
(6)
An example
What are OZs?
Introduced with the Tax Cut and Jobs Act of 2017, OZs were and are an effort to redirect private capital into historically overlooked economic areas. These areas (“zones”) were identified by the individual states and thereafter certified by the Treasury Secretary, a process which stretched into 2019.
There are – in general – two ways to invest in an OZ:
a direct investment in a trade or business that operates within an OZ or in real estate located within
an OZ; or an indirect investment via a fund which does the same.
Remember that an OZ’s purpose is to generate new
investment. An intuitive example is starting a new business in an OZ zone.
Buying an existing business can also work, but you must be willing to spend at least
as much on new assets as you are spending to buy the existing assets. Real estate can certainly work, but just buying an existing
building or raw land will not suffice. The Code wants to see substantial
improvement of the existing real estate. You are either renovating or building new if you want to OZ.
OZs have been compared to Section 1031 tax-free
exchanges, but they actually operate quite differently. For example, to obtain
the full benefit of a Section 1031, one has to reinvest (at least) the full sales
price of the real estate sold. OZs are very different: one has to reinvest only
the gain portion of the proceeds, not the total proceeds.
EXAMPLE: Let’s say you sell a building for $12 million
with a gain of $3.5 million.
If you want a (full) Section 1031 like-kind exchange,
you will have to invest at least $12 million (and meet other requirements) in
replacement real estate.
If you want a (full) OZ, you will have to invest $3.5
million in an OZ-located business, real estate, or a fund that does that for
you.
You see what powers the OZ: you must have a capital
gain somewhere on your return. It does not matter what type of taxpayer you
are. An individual, decedent, corporation, trust or estate will qualify – as
long as you have capital gain as an admission ticket.
BTW your OZ investment must be equity. It cannot be
debt back to you, much to the disappointment of tax planners nationwide.
And you have 180 days after the sale date to get the
investment done. You cannot invest before the sale date. A Section 1031 can do
that but not an OZ.
The driving force behind OZs are two potential tax
breaks: one a tax deferral and the other an outright tax exclusion. These two
can vary depending upon whether one invested in 2026 or earlier or invests in 2027
and later.
Pre-2027 OZs
(1)
The tax deferral
a. Taxes
on the underlying sale are not payable until December 31, 2026 (or when you
sell the OZ, if earlier).
b. There
is a bonus for holding on to the OZ.
i. Only
90% of the gain will be taxable if you hold for at least 5 years.
ii. That
changes to 85% if you hold for at least 7 years.
1. COMMENT:
I doubt that we will see many 7-years as the rules were not finalized until
2019.
c. If
you have a pre-2027, you will owe tax on December 31, 2026, unless you sold the
property previously.
i. If
you haven’t sold, you may want to start freeing-up cash for tax.
(2)
The tax exclusion
a. This
one is tricky: all gain AFTER the original sale AND before December 31, 2047 is
tax-free IF you hold the replacement property for at least 10 years.
i. Yep,
the 2047 throws me too. I presume the 2047 has something to do with how the CBO
scored the tax bill.
ii. If
not sold by then, one steps-up basis in the property to its December 31, 2047
fair market value.
iii. Let’s
be frank: all we are after is to hold for at least 10 years. 2047 is an
after-thought, if it is even a thought.
b. Example:
You sell something in 2026 for a $1 million gain. You reinvest the $1 million
and sell the replacement property 11 years later for a $2 million gain
(totaling $3 million in gains over the transaction cycle - congrats). You will
pay tax on the $1 million in 2026 – no one escapes 2026. You however will not
pay tax on the subsequent $2 million, as you would have held the replacement
property for the (actually, more than) required 10 years.
(3)
Tax planners are a tricky lot
a. Can
one rollover the gain otherwise taxable at December 31, 2026 and defer the tax
one more time?
i. In
the preceding example, that would be the $1 million.
b. The
IRS was clear, blunt, and concise: NO!
i. No
two bites at the same apple.
ii. The
cite for the tax nerds is IRS Notice 2026-40.
Post-2026 OZs
(1)
The big change is getting rid of that
one-size-fits-all-tax-recognition-date (of December 31, 2026). The new rules
say that you will owe tax on the deferred gain on the 5th
anniversary of when you invested the gain.
a. Makes
more sense to me. I suspect that the original December 31, 2026 date had more to
do with Congress being unsure whether the Code section would even be renewed.
(2)
You still have the 10% gain exclusion if you
hold the OZ for at least 5 years.
(3)
However, there is no longer a 15%
exclusion.
(4)
Congress replaced that 2047 nonsense with
a 30-year anniversary of the investment date.
a. Once
again, do not get caught-up here. What we are after is to hold for at least 10
years.
(5)
Congress provided a specialized break for
rural OZs.
a. The
10% gain exclusion is 30% instead.
b. Rural
is described (generally) as 50,000 people or less.
Gains reported through
Schedule K-1
One has 180 days to invest capital gains into an OZ.
How does that rule work when the capital gain is reported via a Schedule K-1?
If you sell an asset personally, you are (likely)
aware of the sale and its sale date. You can more easily work with the 180-day window.
A sale through a passthrough entity (a partnership or
S corporation, for example) can be more problematic. The passthrough may do an
excellent job of alerting one of the sale and gain; it is equally likely that
it may not. Take a partnership that extends its return, for example. As the tax
preparer for a partner, my first knowledge of that gain may occur in September
when the extended K-1 arrives. That would – without some relief – eliminate an
OZ roll as a viable planning option.
So the Regulations provided relief.
First, the passthrough entity itself may decide to
reinvest into an OZ. If so, then the 180 days begins with the exact date of
sale. This would, of course, take the passthrough owners out of it.
Second, the entity may decide not to directly invest and
instead distribute the gain to its passthrough owners. Each owner can decide
whether or not to invest, as one owner does not bind another. However, if one
does invest, when does the 180-day window start?
The passthrough owner has three options:
(1)
The actual date of the sale (of course);
(2)
The last day of the passthrough entity’s
taxable year (most likely December 31);
(3)
The unextended due date of the passthrough
entity return (most likely March 15).
I am leaning toward Option (3) as my default.
Another tax form
There has to be a capital gain to power an OZ, so expect your return to include a Schedule D (where capital gains are reported) and perhaps Form 8949 (providing supplemental detail to the Schedule D).
Reinvest the gain into an OZ and you will add this beauty to your tax return:
It has four parts, and you will attach (and update) the form each year as the OZ goes through its life cycle - from acquisition to disposition.
An example
Let’s walk through what happens depending on whether one has a pre-2027 or post-2026 OZ.
EXAMPLE: You have a $7.5 million sale with a gain of $1.5 million.
Pre-2027
(1) You sold in 2025.
(2)
You bought the OZ in 2026.
(3)
The $1.5 million gain can be deferred only
until December 31, 2026. Sorry.
(4)
There is no 10% or 15% exclusion, as you hit
the gain recognition date (December 31, 2026) well before any 5- or 7-year
anniversary.
a.
Had you sold and bought in 2019, however,
you would qualify for the 7-year 15% exclusion.
(5) However, the 10-year exclusion is still possible. You would keep the OZ, pay the tax in 2026 and hold it for (at least) 10 years. If you do, any further gain (that is, beyond the $1.5 million you already paid tax on) would be tax-free.
Post-2026
(1) You sell in 2027.
(2)
You buy the OZ in 2027.
(3)
Tax on the $1.5 million is deferred for 5
years. You will not pay tax until sometime in 2032.
(4)
You will get a 10% exclusion at the 5-year
anniversary, meaning that only $1,350,000 of the gain will be taxable. (The 10%
becomes 30% if you reinvest in a rural OZ).
(5) Same as the pre-2027, the 10-year exclusion is possible.
Closing thoughts
There are some nice tax features to an OZ, but remember that we are talking about investments. Not all investments make sense to all investors. An OZ might appeal to a business owner recognizing a large capital gain upon the sale of his/her business. An OZ would not appeal to a well-maintained older CPA who sold his practice via a 5-year compensation-as-purchase arrangement.
This is a longer-term investment. The Code is straightforward about this with its 5-year, 7-year and 10-year thresholds.
Be sure to consider state taxes. We have discussed the federal tax considerations, but your individual state may or may not follow the federal rules.
Do not overlook the
routine tax reporting of an OZ. If you start an OZ business as a single-member
LLC, for example, you will be filing a Schedule C with your annual personal return. If the LLC is instead owned by a partnership in which are a partner,
then you will report the K-1 every year on Schedule E. Yes, the December 31, 2026/5-year/7-year/10-year
stuff is also out there, but that is in addition to the routine annual reporting.
And remember: if you already own an OZ, hopefully your tax advisor has been in contact about (a) whether the December 31, 2026 deadline matters to you and (b) if it does, how much it matters. If this is you, you likely have deferred taxes due for 2026.
