November 2018 – Opportunity Zones – A Road to Realizing Capital Gains Benefits by Investing in Low- Income Communities
The Tax Cut and Jobs Act of 2017, which became effective in December 2017, included provisions that allow for the deferral (and possible reduction or exclusion) of an unlimited amount of capital gains on sales of appreciated property where the gains are timely invested in a “qualified opportunity fund” which in turn invests in a “qualified opportunity zone” (the “Opportunity Zone Program”). Click here to see Internal Revenue Code Section 1400Z-2, which sets forth the applicable provisions of the Opportunity Zone Program.
On October 19, 2018, the Department of the Treasury and the Internal Revenue Service released proposed regulations and related materials that provide guidance under Section 1400Z-2, subject to a 60-day comment period and approval of the final rules which is expected early next year; however, taxpayers are permitted to rely on the proposed regulations prior to enactment of the final rules if the taxpayer “applies the rules in their entirety and in a consistent manner.” Click here to see the proposed regulations. Click here to see IRS Opportunity Zone Frequently Asked Questions.
Purpose of the Opportunity Zone Program
The purpose of the Opportunity Zone Program is to spur economic development and job growth by encouraging capital investment in low-income and distressed communities across the country. Over 8,700 such communities in all 50 states, Washington, DC, and five U.S. Territories have been designated as “Opportunity Zones” under the Opportunity Zone Program. Click here to see a map of the existing Opportunity Zones.
Al Puchala, CEO of CapZone Impact Investments LLC, a Qualified Opportunity Fund formed to drive ESG + Resilience investments into Opportunity Zones throughout the U.S., said “This new national program is designed to connect tax benefits to purpose by directing capital flows at scale into low-income communities. The simplicity and elegance of the new law’s approach is illustrated by the fact that all types of capital gains are eligible to be monetized to make new equity investments in virtually any sector, so long as the business or project resides in an Opportunity Zone. It is important to note that market discipline will still be required to make successful investments and thus generate new capital gains that are tax free, as long as the investor holds over the long term.”
How it Works
The following is a high-level summary of how the Opportunity Zone Program works:
Deferral Election. A taxpayer (individual, corporation, partnership or other entity) that would otherwise recognize a capital gain on the sale or other disposition of property to an unrelated person can elect (by filing a Form 8949 with its tax return for the year in which the gain would have been recognized) to defer recognition of all or a portion of the gain by investing the gain proceeds in a Qualified Opportunity Fund (QOF) within 180 days after the sale that gave rise to the gain. The types of transactions giving rise to an eligible capital gain are not limited and could range from a simple sale of securities on a public stock exchange, to sales of appreciated real estate, art or other property, to a complex business sale.
Recognition of Deferred Gains. Gains that are properly deferred must be recognized by the taxpayer on the earlier of the sale of the taxpayer’s QOF investment or December 31, 2026. The amount of gain to be recognized will be the lesser of the fair market value (FMV) of the QOF investment and the amount of the gain that had been deferred, in each case less the taxpayer’s basis in the QOF investment.
Potential Reduction in Recognized Gains. Initially the taxpayer’s basis in the QOF investment is zero, but if that investment is held for at least five years, the basis increases by an amount equal to 10% of the deferred gain; and if the investment is held for at least seven years, the basis increases by an additional 5% of the deferred gain. As a result, the taxpayer can realize capital gains tax savings, not just deferral, by holding its QOF investment for at least five years. For example, if a QOF investment is made prior to the end of 2019 and is held until December 31, 2026 (i.e., for more than seven years), then the taxpayer will recognize gain on its 2026 tax returns equal to 85% of the original amount of the deferred gain.
Potential Permanent Exclusion of Gains on a QOF Investment. In addition to the foregoing, if a taxpayer holds a QOF investment for at least ten years from the original investment date, then the taxpayer can elect to have the basis in its QOF investment stepped up to equal its FMV at the time the investment is sold or otherwise disposed of. As a result, the taxpayer would recognize no gain, and owe no taxes, on the appreciation in value of the QOF investment during the 10+ years in which it was held by the taxpayer.
A Simple Illustration. The following example illustrates the potential tax benefits of the Opportunity Zone Program:
Assume that a taxpayer: (1) sells appreciated property on January 1, 2019 in a transaction that (but for the Opportunity Zone Program), would generate a capital gain (short- or long-term) of $100; (2) elects to defer the $100 of gain and on March 31, 2019 invests $100 into a QOF; and (3) holds the QOF investment until December 31, 2029, at which time the taxpayer sells its QOF investment for $400 and elects to have the basis in the QOF investment stepped up to FMV.
In this example, the taxpayer would: (1) recognize a gain of $85 on December 31, 2026 (note that the recognized gain would have the same tax characteristics (e.g., short- or long-term) as the gain that was deferred), being the original $100 of deferred gain reduced to reflect the 10% and subsequent 5% step-up in basis after years five and seven of holding the QOF investment; and (2) recognize no additional gain upon the sale of the QOF investment for $400 in 2029 as a result of the basis in the QOF investment having been stepped up to full FMV at that time. Thus, the taxpayer would recognize a capital gain on $85 of appreciation and would recognize no gain on $315 of additional appreciated value.
Click here to see additional examples from the Economic Innovation Group of how the Opportunity Zone Program can impact investment returns over time.
Many of the critical details of the Opportunity Zone Program lie in the definitions of the following key terms:
Qualified Opportunity Zone (QOZ) – Over 8,700 census tracts identified as low-income communities by the governors of all 50 states and five U.S. territories and the mayor of Washington, DC, and certified as QOZs by the Treasury Department and the IRS.
Qualified Opportunity Fund (QOF) – A domestic investment vehicle that: (1) is an entity classified as a corporation or partnership for Federal income tax purposes; (2) is organized for the purpose of investing in QOZ Property; and (3) holds at least 90% of its assets in QOZ Property, with this test being measured by the average of the percentage of QOZ Property held by the QOF at the end of the first six months of the taxable year and at the end of the taxable year. (Note: The regulations permit the QOF to initially self-certify to the IRS that it meets the requirements of a QOF, and annually self-certify that it is in compliance with the 90% asset test.)
Qualified Opportunity Zone Property (QOZ Property) – Either QOZ Stock, QOZ Partnership Interests or QOZ Business Property.
Qualified Opportunity Zone Stock (QOZ Stock) – Capital stock (including preferred stock) acquired by the QOF directly from a corporation after December 31, 2017 as original issue solely for cash; provided that during the time the QOF holds the QOZ Stock the corporation qualifies as a QOZ Business.
Qualified Opportunity Zone Partnership Interest (QOZ Partnership Interest) – Any capital or profits interest in an entity classified as a partnership for Federal income tax purposes (including a limited liability company that has elected to be taxed as a partnership) acquired by the QOF directly from the entity after December 31, 2017 solely for cash; provided that during the time the QOF holds the QOZ Partnership Interest the entity qualifies as a QOZ Business.
Qualified Opportunity Zone Business Property (QOZ Business Property) – Tangible property acquired by a QOF (or a QOZ Business) after December 31, 2017 where (1) the original use of the property in the QOZ commences with the QOF (or a QOZ Business) (e.g., proceeds from the QOF investment are used to construct the property) or the QOF (or a QOZ Business) substantially improves the property; and (2) such property is used in a QOZ while it is held by the QOF (or a QOZ Business).
“Substantially improves” means that, during the 30-months following the acquisition of the QOZ Business Property, the QOF (or the QOZ Business) makes additional investments in the property such that the QOF’s basis in the property increases by an amount equal to at least 100% of the QOF’s (or the QOZ Business) basis in the property immediately following its acquisition. In other words, if the QOF (or the QOZ Business) purchases existing property, it must essentially double its investment in the property during its first 30 months of ownership by making improvements. Note, however, that the proposed regulations state that when applying this test to an acquired building located in a QOZ, substantial improvement to the property is measured by additions to the basis in the building, and not the underlying land. For example, if a QOF acquires improved real property for $500 and allocates $250 of the purchase price to each of the land and existing structures, then subsequently invests $250 in improvements to the building, all $750 of the QOF’s investment would be characterized as QOZ Business Property.
Qualified Opportunity Zone Business (QOZ Business) – A trade or business which meets the following requirements:
- substantially all of the tangible property owned or leased by the business is QOZ Business Property, where “substantially all” means at least 70%;
- at least 50% of the entity’s gross income is derived from the active conduct of the QOZ Business;
- a substantial portion of the entity’s intangible property is used in the active conduct of the QOZ Business;
- less than 5% of the entity’s property is attributable to “nonqualified financial property” (debt, equity, derivatives and the like, but excepting a reasonable amount for working capital held in cash, cash equivalents, short term debt instruments, and trade receivables); and
- the entity’s business is not any of the following: golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
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This Client Alert is for the benefit of our clients and friends and provides only a high-level summary of the subject matter. It is not intended to be comprehensive or address any particular transaction or set of facts, and should not be relied upon as legal advice or a legal opinion. In addition, the proposed regulations governing the Opportunity Zone Program are not final and different or additional regulations or interpretations may be adopted.