CPA Chris Falco, of the Washington accounting firm Falco Sult, discusses how the federal government is encouraging investment into low-income/distressed communities by providing New Market Tax Credits (NMTC) as incentives.
“These credits were intended to encourage investment for the economic development of designated low-income areas. The Tax Cuts and Jobs Act of 2017(TCJA) established new rules about such investments,” said Falco, a founding partner of Falco Sult.
Rather than incentivizing investment using credits to offset tax liability, the new rules allow for the deferral of capital gains. Any proceeds from the sale of investments subject to capital gains tax that are reinvested in so-called Opportunity Zones (OZ), defined in U.S. Code § 1400-Z, within 180 days of the sale or exchange of investment subject to taxable gain, may elect to be deferred until the sale of the investment in the Opportunity Zone fund or until December 31st, 2026, whichever occurs sooner.
The new rules adopted the same definition of “low income communities” as the NMTC but made a few changes to the form and recognition of the gains that result. “The opportunity for these communities is significant; there is estimated to be trillions of unrealized capital gains currently held by U.S investors,” noted Falco. “NMTC almost always impacted debt investments, whereas the new regulations will have more of an impact on equity investments. As such, NMTC have been in the past more attractive to lenders, whereas the OZ program may attract a greater variety of investors such as large corporations and individuals.”
Qualified Opportunity (QO) Funds are certified by the US Treasury and are intended to mitigate risk and generally make it easier for investors to pool their resources into communities in need of economic development. A QO fund is organized as a corporation or a partnership and is required to hold at least 90% of its assets in qualified Opportunity Zone stock, partnership interest or business property. QO funds are specifically designed to assist in starting new businesses, developing abandoned property, and building low-income housing in distressed communities. If a fund drops below the 90% threshold at any time, a penalty is assessed to the fund as an underpayment.
Depending on the holding period of the investment, the taxpayer may be allowed to step up the basis of their QO investment. The basis of any capital gain contributed to the investment may be stepped up by 10% if the investment is held for 5 years or more, and an additional 5% if held for 7 years or more.
“It is important to note, for planning purposes, that the cutoff date of December 31, 2026 will trigger recognition of the deferred gain even if no sale has occurred. The taxpayer will recognize all or a portion of the deferred gain in gross income for the 2026 tax year,” concluded Falco. “If such a situation occurs, the basis in the QO fund will be increased by the amount of that gain. If a taxpayer holds their investment in a QO fund for 10 years or more, there is an election that can be made to step up their basis to fair market value at the time of disposition to eliminate further capital gains.”
