Last year’s Tax Cuts and Jobs Act established certain census tracts in lower income communities across the country as “Opportunity Zones” in order to encourage development within those areas. More than 8,700 communities in all 50 states, the District of Columbia, and five U.S. territories have been designated as Qualified Opportunity Zones.
Under the terms of the TCJA, investors can defer capital gains from any investment by reinvesting the proceeds into a qualified opportunity fund, also known as a QOF or, for the purposes of this article, a “Fund.” These Funds are private investment vehicles to develop and redevelop projects within the zones, including investments in new or substantially improved commercial buildings, equipment, multifamily complexes and Qualified Opportunity Zone businesses. The subsequent appreciation of the investment in a Fund can qualify for permanent exclusion of the capital gain.
Congress created the Opportunity Zone program as an economic development tool to incentivize the movement of capital into designated areas in an effort to reduce poverty and increase employment. The tax incentives are:
- Temporary deferral of capital gains until the investment is sold, or December 31, 2026 at the latest.
- Step up in basis of the Fund of 10% of the deferred gain if the investment is held five years; an additional 5% (for a total of 15%) for investments held seven years; and permanent exclusion of the capital gain on the appreciation of the Fund for investments held 10 years or more.
What kinds of capital gains are eligible?
The Opportunity Zone tax incentive is available to any individual, partnership, C or S corporation, trust or estate.
The regulations make it clear that only capital gains between unrelated parties are eligible for tax deferral, so this includes both short-term and long-term capital gains from any investment. Also included are gains from the sale of real estate known as Section 1231 gains and unrecaptured Section 1250 gains.
A taxpayer has 180 days to reinvest the capital gain amount into a Fund. There is no requirement that these funds need to be segregated during this time period, which differentiates this from the rules of like-kind or 1031 exchanges.
Only the reinvested gain is eligible for these tax benefits; additional investment into the Fund does not qualify for the gain exclusion. For gains realized by pass-through entities, the rules generally allow either the entity or the partners, shareholders or beneficiaries to elect deferral. If gains are not deferred by the entity, the owner’s 180-day period generally begins on the last day of the entity’s taxable year. If the owner knows both the date of the entity’s gain and its decision not to elect deferral, the owner can begin its own period on the same date as the start of the entity’s 180-day period.
The proposed regulations also clarify that an investment in a Fund must be an equity interest, including preferred stock or a partnership interest with special allocations. Debt instruments do not qualify; however, a taxpayer can use a Fund investment as collateral for a loan.
If an investor disposes of its entire original interest in a Fund, which normally would trigger inclusion of the deferred gain, the investor can continue the deferral by reinvesting the proceeds in another Fund within 180 days. This allows investors to escape bad deals without forfeiting the deferral benefit.
What constitutes a ‘Qualified Opportunity Fund?’
A Qualified Opportunity Zone Fund is a private investment vehicle taxed as a corporation or partnership (including LLCs) that is organized for the purpose of investing in Qualified Opportunity Zone (QOZ) property. At least 90% of its assets must be QOZ property, which includes stock, partnership interests and business property. A Fund cannot invest in another Fund.
The definition of QOZ “business property” is particularly important, as a Fund may invest in such property either directly or through an equity interest in a partnership or corporation that owns it. With that in mind, QOZ business property is defined as tangible property used in a trade or business that meets the following three conditions:
- The property is acquired by purchase after December 31, 2017;
- Either the original use of the property in the zone commences with the Fund, or the Fund substantially improves the property (the Fund or Fund-owned business in both cases); and
- During substantially all of the holding period for the property, substantially all of the use of the property is in the zone.
Property is treated as “substantially improved” if the Fund makes capital expenditures in excess of the amount of initial basis of the property during the 30-month period after acquisition. (This has been referred to as “doubling down,” because basis needs to be doubled.)
The proposed regulations address the issue of land and substantial improvement. The regulations exclude land from the determination of whether a purchased building in an Opportunity Zone has been substantially improved. Improvement is measured only by the Fund’s additions to the adjusted basis of the building.
A Fund can own stock or a partnership interest in a QOZ business, provided it was originally issued to the Fund after December 31, 2017 and as long as substantially all of the business’s leased or owned tangible property is QOZ business property. The proposed regulations provide that “substantially all” means at least 70% of the leased or owned tangible property.
The tax benefits can be further enhanced when combined with other credits, such as the Low-Income Housing tax credit and the New Markets tax credit. Additional rules cover self-certification of Funds, valuation for purposes of the 90% asset test, disqualified businesses and other matters.
The IRS promises more guidance to come, but in the meantime, taxpayers generally may rely on these rules if they apply them in their entirety and in a consistent manner.
If you have any questions, please do not hesitate to contact myself or a member of our tax department for more information.
This post was contributed by Jim Hamilton, head of Weiss & Company’s Tax Planning & Compliance Department and one of our foremost authorities on tax-related issues. You can reach Jim at 847-441-8800 or by email at firstname.lastname@example.org.