The Tax Cuts and Jobs Act of 2017 created a new section of the Internal Revenue Code (§1400Z-2) that is of potential interest to investors, business owners, and developers.
This legislation provides the possibility for deferral of all, and permanent exclusion of a portion of, taxable gain from the sale of property, if the amount of gain is reinvested in an Opportunity Zone Fund (a “Fund”) within 180 days after the sale. Funds are investments in businesses that are not specifically prohibited by the statute and that are located in specified low-income communities (the “Communities”). Eligible Communities have been designated in each state, including in each Maryland county and Baltimore City.
Normally, when an owner sells property, the owner is taxed on the gain. There are ways for owners to defer gain under certain circumstances. Owners of real estate can postpone the recognition of gain on disposition if they utilize the mechanisms prescribed in §1031 of the Internal Revenue Code. However, the requirements of §1031 can be quite burdensome and limiting. For example, §1031 applies only to real estate.
New §1400Z-2 has broader application, although there are certain important limitations. In general it applies to the sale of “property” and is not limited to real estate. Instead of having to invest all of the sale proceeds in a new investment to totally avoid recognition of gain, as is required under §1031, pursuant to the new law only the taxable gain portion of the sale proceeds must be invested in a Fund to obtain its benefits. The investment must occur within 180 days of the sale of the asset triggering the gain.
If the Fund investment is held for five years, 10% of the deferred gain is permanently excluded from recognition. If the Fund investment is held for seven years, an additional 5% of the deferred gain is excluded (for a total of 15% permanent exclusion).
The deferral ends on the earlier of (i) the disposition of the Fund investment, or (ii) December 31, 2026 (even if the Fund investment is not sold). Thus, a taxpayer who wishes to enjoy the maximum 15% permanent exclusion must sell the existing property and invest the gain proceeds in a Fund by December 31, 2019.
Therefore, §1400Z-2 does not afford a taxpayer as much flexibility in the deferral of the gain as a taxpayer can have under a §1031 like-kind exchange. In such an exchange, the taxpayer can control when the deferred gain will be recognized.
In addition to the tax benefits relating to the disposition of the original asset, §1400Z-2 also provides potential tax benefits relating to the investment of the gain from the disposition of the original asset in a Fund. If the Fund investment is held for at least ten years, the taxpayer can make an election to increase the basis of the Fund investment to equal the fair market value of such investment on the date that the Fund investment is sold or exchanged. Thus, one can avoid income tax on the entire gain realized on the Fund investment. The only other way a taxpayer gets a step-up in basis is by dying. Using a Fund is a far preferable planning technique!
To date, there are no regulations issued, and the Treasury Department has given very little guidance so far on §1400Z-2. However, it seems that many taxpayers should be able to utilize the benefits of the Opportunity Zone Fund provisions of the new tax law.
We will monitor developments relating to §1400Z-2 and will share them from time to time.