Opportunity Zones: Tax Reporting How-To
The Qualified Opportunity Zone program, created by the Tax Cuts and Jobs Act of 2017, and contained in Section 1400Z-2 of the U.S. Internal Revenue Code of 1986, as amended (the Code), incentivizes investment in underserved communities. At Cadre, our focused strategy and pipeline of Opportunity Zone transactions with institutional operators position us to deliver what we believe is an attractive portfolio of qualifying investments that also feature material tax benefits. Through our program, investors can:
- Defer taxes on currently realized capital gain until the end of 2026.
- Reduce the amount of deferred taxes owed by up to 15%.
- Eliminate tax on capital gains from the sale or disposition of the investment if held for at least 10 years.
Investors who have recently joined the Cadre Qualified Opportunity Zone platform and have begun evaluating or investing in available transactions may be wondering, “What happens next, in terms of taxes?” We’ll cover the basics in this guide, which summarizes the U.S. federal income tax reporting and filing obligations associated with an investment in a Qualified Opportunity Fund pursuant to the Qualified Opportunity Zone program.
We start with an illustration of major investment milestones, then provide a primer on IRS Form 8949 and several sample filings.
The recommendations contained herein are based on early release drafts of IRS Form 8949 and accompanying instructions and do not take into account a taxpayer’s specific circumstances which may affect tax reporting obligations. Typically, taxpayers may not rely on IRS draft forms, instructions, and publications for filing their U.S. federal income tax returns. If taxpayers file for an extension for their U.S. federal income tax returns, the finalized IRS Form 8949 and accompanying instructions (or additional official guidance) may become available prior to the extended due date of such returns. Taxpayers may also file their U.S. federal income tax returns and IRS Form 8949 based on the current early release draft and accompanying instructions, but there is a risk that such tax returns and form may have to be subsequently amended based on future official guidance. All investors should consult their tax or legal advisers prior to filing any tax returns relating to their investment in a Qualified Opportunity Fund and this guide should not be construed as tax advice to a particular investor or investors.
Major investment milestones
To better understand the U.S. federal income tax reporting components of an investment in a Qualified Opportunity Fund, it can be helpful to first consider what a full investment life cycle may look like:
- Capital Gains Realization Event–Feb 15, 2019
Taxpayer generates a capital gain and is eligible for tax benefits if the gain is reinvested into a Qualified Opportunity Fund within 180 days.
- Investment + Deferral–Feb 15, 2019
Taxpayer invests an amount of cash equal to the gain into a Qualified Opportunity Fund and defers capital gain tax liability until the earlier of (i) the investment sale date or (ii) December 31, 2026.
- Year 5 Tax Reduction–Feb 15, 2024
Deferred capital gains tax reduced by 10%.
- Year 7 Tax Reduction–Feb 15, 2026
Deferred capital gains tax reduced by an additional 5%.
- Tax Recognition Date–Dec 31, 2026
Assuming that the asset has not yet been sold, taxpayer must report and pay the deferred capital gains tax liability, taking into account the reductions mentioned above.
- Disposition + Elimination–On or after Feb 15, 2029
Since the asset has been held for 10 years, the investor may increase its basis in the investment to its fair market value at the time of sale, thereby eliminating federal capital gains taxes on such sale.
Let’s take a closer look at the tax reporting requirements for the first two milestones—liquidation and Qualified Opportunity Fund investment + deferral—which both involve IRS Form 8949.
A primer on IRS Form 8949
Generally, IRS Form 8949 is an existing form used to reconcile amounts of short- or long-term capital gains that were reported to the taxpayer and the IRS on Forms 1099-B or 1099-S (or any substitute statements) with the amounts reported by the taxpayer on his or her U.S. federal income tax return.
More recently, the IRS released updated draft instructions for the form which specify rules for eligible gains invested in a Qualified Opportunity Fund. When an investor files a U.S. federal income tax return for the year in which the capital gain otherwise would have been reported, the investor will attach an additional IRS Form 8949 to the return, reporting the election to defer all or a portion of such gain.
Different sections of the form are completed depending on the type of capital gain and cost basis being reported, including:
- Part I—Used for reporting short-term capital gains (corresponding to capital assets held less than a year) and includes three check boxes:
- (A) for reporting short-term capital asset transactions for which the taxpayer received an IRS Form 1099-B (or substitute statement) showing that the basis of the capital asset was reported to the IRS. Such transactions typically include sales or exchanges of certain stock or other “covered securities” from a broker. For reporting purposes, these transactions may be aggregated by the taxpayer on IRS Form 8949, and do not require a code to be entered in column (f) or any adjustments in column (g).
- (B) for reporting short-term capital asset transactions for which the taxpayer received an IRS Form 1099-B (or substitute statement), but which did not show that the basis of the capital asset was reported to the IRS. Such transactions include sales or exchanges of certain assets other than covered securities from a broker for which an IRS Form 1099-B (or substitute statement) was received but did not show the basis of the asset or such basis was not reported to the IRS. For reporting purposes, these transactions may be reported separately by the taxpayer on IRS Form 8949 and require a code to be entered in column (f) and an adjustment to be made in column (g) in order to account for the basis which was not otherwise reported to the IRS.
- (C) for reporting short-term capital asset transactions for which the taxpayer did not receive an IRS Form 1099-B (or substitute statement). Such transactions may include sales or exchanges of securities or other capital assets from a non-broker.
- Part II—Same as Part I but used for reporting long-term capital gains (corresponding to capital assets held over one year). Boxes (D), (E), and (F) correspond to boxes (A), (B), and (C) in Part I, respectively.
Note: Taxpayer may file IRS Form 8949 with only one of boxes (A), (B), or (C) in Part I checked, and only one of boxes (D), (E), or (F) in Part II checked. If a taxpayer has transactions which would require more than one of the boxes checked, multiple IRS Forms 8949 should be used.
Simplified sample form showing taxpayer reporting short- and long-term sales of stock
Reporting Opportunity Fund Deferrals
When electing to defer a capital gain through an Opportunity Fund, the taxpayer would report the capital gain on IRS Form 8949 in the standard manner, but include an additional IRS Form 8949 to report the deferral of capital gain in the following manner:
- Use Part I and check box (C) if deferring short-term capital gains
- Use Part II and check box (F) if deferring short-term capital gains
- Enter the Name and EIN of the Qualified Opportunity Fund in box (a) Description if property
- Enter date of investment in box (b) Date acquired
- Enter “Z” in box (f) Code
- Enter investment (amount) in boxes (g) Amount of Adjustment and (g) Gain or (loss)
Taxpayers who report other capital gains with either box (C) on Part I or box (F) on Part II checked may use the same IRS Form 8949 to report the deferral of capital gain as specified above.
Example 1: Taxpayer invests short-term capital gains equally into a single Qualified Opportunity Fund
Example 2: Taxpayer invests short-term capital gains into multiple Qualified Opportunity Funds
Example 3: Taxpayer invests short-term and long-term capital gains into a single Qualified Opportunity Fund
It’s important to note that investors should not expect to receive any tax forms or reports from Cadre, save for investor communications that Cadre will provide in the ordinary course to its investors. Therefore, investors should consult with their tax advisers regarding the obligation to report the appropriate amount of deferred gain on the Tax Recognition Date as well as tracking the investor’s basis in the Qualified Opportunity Fund interest.
Although the Opportunity Zone rules are still taking shape, the current regulations suggest that a taxpayer’s basis is otherwise subject to the normal adjustments associated with allocations of income and loss on the Qualified Opportunity Fund’s Schedule K-1.
Investors should also note that the Qualified Opportunity Fund itself will use a separate form (IRS Form 8996) to self-certify (i) that it is organized as a Qualified Opportunity Fund to invest in Opportunity Zone property, and (ii) on an ongoing basis, that it continues to meet the various requirements of Qualified Opportunity Fund status. Cadre and its advisers will handle the preparation and filing of this form.
Note on State Tax Considerations
Whether the federal tax benefits stemming from the Qualified Opportunity Zone program will translate into state tax benefits (and the associated state-level information reporting requirements) will depend on whether and how a state conforms to the Code. Certain states have a regime of automatic conformity to the Code (e.g., Illinois and Colorado), whereas other states have a fixed-date conformity which has been updated since the enactment of the Qualified Opportunity Zone rules (e.g., Georgia, Maine). Some states have even introduced legislation to offer additional state tax incentives for Qualified Opportunity Fund investments separate and apart from a such state’s conformity to the Qualified Opportunity Zone regime.
Taxpayers in states which have not updated their Code conformity provisions to incorporate components of the legislation (e.g., California, Minnesota) or which have affirmatively decoupled from the Qualified Opportunity Zone provisions (e.g., North Carolina, Hawaii) may lose out on state tax benefits stemming from the provisions and may face additional administrative and information reporting burdens.
For example, taxpayers filing state tax returns in a non-conforming state and making an investment into a Qualified Opportunity Fund which holds property located in the same state, may be required to recognize the capital gains invested into the Qualified Opportunity Fund in the year in which the gain is realized, and will not be granted any basis step-up for amounts invested and held in a Qualified Opportunity Fund. When the gain is ultimately realized at the federal level, taxpayers would want to ensure that such gain is not taxed by the state a second time. This mismatch between the federal and state tax treatment of Opportunity Fund investments necessitates that taxpayers keep detailed schedules separately tracking their federal and state tax treatment.
A single Qualified Opportunity Fund investment might involve multiple states, forcing a taxpayer to assess the state tax considerations in the state where the fund and Qualified Opportunity Zone are located, and all of the states where the taxpayer is already paying taxes. Depending on whether all of these states conform to the program, the taxpayer might be required to include the capital gain in computing his or her tax liability in one state while deferring that same gain in a different state. Additionally, state apportionment treatment of capital gains varies from state to state and may also depend on whether the gain relates to the sale of tangible or intangible property. For conforming states, taxpayers should examine their apportionment factors to determine whether any gain deferral or non-recognition is properly reflected. Where a state includes net gains from the sale of capital assets in the sales factor and also conforms to the Qualified Opportunity Zone program, taxpayers should consider as to the year in which gains should be properly included in the apportionment factor. Furthermore, investment in a Qualified Opportunity Fund which owns property located in a state other than a state where the taxpayer is engaged in a trade or business may create concerns related to an expanded nexus leading to increased state tax filing requirements.
The laws relating to the Qualified Opportunity Zone program and associated filing requirements at both the state and federal levels are currently uncertain and subject to change. All investors are urged to consult their tax advisers to ascertain the applicable federal and state implications and filing requirements prior to making an investment into a Qualified Opportunity Fund and should not construe the above summary as tax advice on which they can rely in light of their particular circumstances.
Note on Investments Through Various Entity Types, Including Trusts
Investors may choose to choose to invest in a Qualified Opportunity Fund using an entity such as a limited liability company (LLC) or a trust. The reporting requirements associated with an investment structured in this manner are highly dependent on the federal tax classification of the entity and the investor’s particular circumstances. Investors using entities to enter a Qualified Opportunity Fund should consider the following:
- An individual may use a grantor trust to invest capital gains in a Qualified Opportunity Fund when such capital gains have either been incurred by the individual or the grantor trust.
- Generally, a “grantor trust” is a trust in which the grantor (i.e., the creator of the trust) retains one or more significant powers over the trust, such that the grantor effectively controls the governance and income of such trust. This determination is driven by the particular facts and circumstances of each trust, but significant powers giving rise to a grantor trust may include the grantor holding a reversionary interest in the corpus or income of the trust, a unchecked power of disposition of the beneficial enjoyment of the corpus or income of the trust, or certain administrative powers exercised by the grantor solely for the benefit of the grantor rather than the trust’s beneficiaries. Investors using a trust to enter a Qualified Opportunity Fund are strongly urged to consult the appropriate tax and legal advisers to determine, based on the particular facts applicable to such investor, the federal tax classification of the trust (including whether the trust is a grantor or complex trust) and how to structure such investment.
- For U.S. federal income tax purposes, the grantor or a beneficiary of the grantor trust is treated as the owner of the activity of the trust. As the deemed owner of the grantor trust, such individual must include the activity of the trust on his or her personal tax return. Therefore, if capital gains were incurred by an individual, but invested into a Qualified Opportunity Fund by the individual’s grantor trust, the individual would report the deferral of these capital gains on IRS Form 8949 in the ordinary manner.
- If the capital gains are incurred by the grantor trust, then the subsequent investment of these gains into a Qualified Opportunity Fund may be reported by the grantor trust on IRS Form 8949 in the ordinary manner.
- Example: Taxpayer realizes a capital gain as an individual and wants to invest such capital gain in a Qualified Opportunity Fund through a grantor trust set up for the benefit of Taxpayer’s child. Taxpayer and his or her spouse are joint filers and the spouse is the grantor of the trust. Unless the trust is treated as a complex trust for federal tax purposes (where the beneficiaries, rather than the grantor, are taxed on certain income received from the trust), Taxpayer should be able to invest in the Qualified Opportunity Fund through the trust.
- If an individual is a joint filer and incurs capital gains which are subsequently invested into a Qualified Opportunity Fund, then such individual may report such capital gains in the ordinary manner either on his or her individual IRS Form 8949 or on a joint IRS Form 8949 which also includes information concerning his or her spouse’s capital
Limited Liability Companies
- The tax reporting obligations regarding an investment made into a Qualified Opportunity Fund through an LLC depend on the tax classification of the LLC. For federal tax purposes, an LLC may be either a regarded entity (e.g., a partnership or a corporation) or a disregarded entity. Typically, if an LLC has only one owner, it is treated by default as a disregarded entity unless an election is made otherwise. Such a single-owner LLC may file an election on IRS Form 8832 to be treated as a corporation. Accordingly, an LLC with more than one owner would be initially classified as a partnership, but may file an election on IRS Form 8832 to be treated as corporation.
- If an LLC is treated as either a corporation or a partnership, it is regarded as an entity that is separate from its owners for federal tax purposes (but see the note below regarding entities owned jointly by spouses). Therefore, if an individual realizes an eligible capital gain, he or she cannot generally use an LLC in which such individual is a member (unless it is wholly-owned by him or her) to invest in a Qualified Opportunity Fund. However, if an LLC taxed as a partnership initially realizes the capital gain, special rules allow any member to invest in a Qualified Opportunity Fund in their own capacity. An LLC that is a regarded entity would file IRS Form 8949 to report capital gains invested into a Qualified Opportunity Fund in the ordinary manner. If the LLC is treated as a disregarded entity, then the sole owner of the LLC would file IRS Form 8949 and report the capital invested into a Qualified Opportunity Fund in the ordinary manner. Investors should consult with their tax and legal advisers to determine the federal tax classification of any entity through which investments could be made into a Qualified Opportunity Fund and how such investments may be structured.
- It should be noted that special rules apply to determine the federal tax classification of an LLC owned solely by an individual and his or her spouse. Under Revenue Procedure 2002-69, the IRS will accept the position that the LLC is either a disregarded entity or a partnership if it is a “qualified entity.” For these purposes, a “qualified entity” means that 1) the business entity is wholly owned by a husband and wife as community property under the laws of a state, 2) no person other than one or both spouses would be considered an owner for federal tax purposes, and 3) the business entity is not classified as a corporation for federal tax purposes. A change in the reporting position will be treated for federal tax purposes as a conversion of the entity. If an LLC is owned by husband and wife in a non-community property state, the LLC should file as a partnership. Investors should consult with their tax legal advisers as to whether they reside in a “community property” state and accordingly how Qualified Opportunity Fund investments can be structured.
- Example: Taxpayer realizes a capital gain as an individual and wants to invest the capital gain in a Qualified Opportunity Fund through an LLC which is treated as a partnership for federal tax purposes (the other partners in the LLC being Taxpayer’s relatives). The Taxpayer cannot contribute an amount of cash equal to the capital gain to the LLC and then have the LLC invest in the Qualified Opportunity Fund. Instead, Taxpayer may invest in the Qualified Opportunity Fund directly or through a disregarded entity.