– Opportunity Zones are a community development tool authorized in the Tax Cuts and Jobs Act of 2017 (H.R. 1) to encourage investment in designated high-poverty neighborhoods. The Opportunity Zone program is intended to spur investment in distressed communities by allowing taxpayers specialized tax treatment, including deferred capital gains, for investments in Qualified Opportunity Funds (QOF), which, in turn, must invest at least 90 percent of their assets in businesses located in qualified Opportunity Zones. The IRS officially designates a census tract as an Opportunity Zone based on the recommendation of a tract by the state’s governor.
– The first set of Opportunity Zones, covering parts of 18 states, were designated on April 9, 2018. Opportunity Zones have now been designated covering parts of all 50 states, the District of Columbia and five U.S. territories
– Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain. If held for more than 7 years, the 10% becomes 15%. Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.
– A Qualified Opportunity Fund is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in a Qualified Opportunity Zone.
– You can get the tax benefits, even if you don’t live, work or have a business in an Opportunity Zone. All you need to do is invest a recognized gain in a Qualified Opportunity Fund and elect to defer the tax on that gain.
– A LLC that chooses to be treated either as a partnership or corporation for federal tax purposes can organize as a Qualified Opportunity Fund.
– You may elect to defer the tax on the amount of the gain invested in a Qualified Opportunity Fund. Therefore, if you only invest part of your gain in a Qualified Opportunity Fund(s), you can elect to defer tax on only the part of the gain which was invested.
- Investors can defer their original tax bill until December 31, 2026 at the latest, or until they sell their Opportunity Fund investments, if earlier.
- Opportunity fund investments held in the fund for at least 10 years are not subject to additional federal capital gains taxes.
– Opportunity Zones offer incentives for private investors to support underserved communities by allowing for deferral or elimination of federal capital gains taxes. Today, these unrealized capital gains are a significant untapped resource. Allowing capital gains to be reinvested in qualified Opportunity Zones can help to spur economic growth in the communities that need it most.
– Among other things, Opportunity Funds can be used to finance new infrastructure and affordable housing, promote job growth, and support workforce development
– QOZ provides a deferral mechanism for short- and long-term capital gains for current investments in nearly all asset classes. A QOZ provides (1) the ability to invest only the gain rather than the principal of a current investment; (2) a broad range of investments eligible for the deferral; (3) a potential basis step-up of 15 percent or substantially more of the initial deferred amount of investment; and (4) an opportunity to eliminate taxation on capital gains post-investment.
– providing tax incentives to invest in QOZs that, in turn, invest directly or indirectly in the opportunity zones.
– Working Capital Safe Harbor. An opportunity fund is permitted by the statute to invest directly in an opportunity zone or indirectly through a partnership (a zone partnership) or a corporation (a zone corporation and collectively, zone entities). However, an opportunity fund that invests directly in property must be engaged in a trade or business and no more than 10 percent of its assets may consist of cash. A zone entity in which an opportunity fund invests must also be engaged in a trade or business and less than 5 percent of the unadjusted basis in its assets may be attributable to financial property, other than a reasonable amount of working capital. One of the concerns raised by these limitations is that they do not allow a sufficient period of time for opportunity funds or the zone entities in which they invest to receive capital and develop new businesses or construct or rehabilitate real estate and other tangible property.
– The Proposed Regulations partially address this concern by providing that a zone entity that acquires, constructs, and/or substantially rehabilitates tangible business property may treat cash, cash equivalents and debt instruments with a term of 18 months of less as a reasonable amount of working capital for a period of up to 31 months if certain conditions are satisfied. In addition, under the safe harbor, tangible property that is being acquired, constructed and/or substantially improved with the working capital and that is expected to qualify as zone property after the expenditure of the working capital will be treated as being used in the active conduct of a trade or business during the construction and improvement period. Thus, if a zone entity raises cash that satisfies the working capital safe harbor and uses that cash to construct a building that is expected to qualify as zone property, the partially completed building qualifies as zone property during the construction phase. This safe harbor does not apply to an opportunity fund that directly holds working capital or constructs property.
Special Rules for Land and Improvements on Land. In order for property to qualify as zone business property, the “original use” of the property in an opportunity zone must begin with an opportunity fund or a zone entity or, if property that existed in the zone is purchased, an amount equal to the purchase price of the property must be used to improve the property. There were concerns that land might not qualify as zone business property because the original use of land can never begin with an opportunity fund or zone entity and, technically, land is never improved. However, Revenue Ruling 2018-29, issued along with the Proposed Regulations, provides a favorable rule, to the effect that, if an opportunity fund or zone entity purchases an existing building located on land that is wholly within an opportunity zone, the “original use” and “substantial improvement” requirements do not apply to the land and a substantial improvement to the building is measured by the additions to basis of the building (and the basis attributable to the land on which the building sits is not taken into account). Thus, if an opportunity fund purchases a property wholly within an opportunity zone for $800,000, consisting of land worth $480,000 and a building worth $320,000, and the opportunity fund invests at least $320,000 to improve the building, then the original $800,000 purchase price plus the $320,000 of improvements to the building qualify as zone business property.
The preamble to the Proposed Regulations implies that vacant real property purchased by an opportunity fund or zone entity does not qualify as zone business property. Nevertheless, the IRS has requested comments as to whether vacant real property that is productively utilized after some period of abandonment could qualify as zone business property.
Capital Gain as Eligible Gain for Deferral. The statute permits taxpayers that realize gain from the sale or exchange of property to defer the tax on that gain and receive up to a 15 percent basis step-up with respect to the gain by investing the gain in an opportunity fund. The Proposed Regulations clarify that only gain that would be capital gain (short-term or long-term) is eligible for deferral and a basis step-up. Capital gain from a position that is or has been part of an “offsetting-positions transaction” (i.e., a straddle or other transaction that substantially diminished the taxpayer’s risk of loss) is not eligible for deferral.
Additional Deferral of Previously Deferred Gains. The Proposed Regulations provide that a taxpayer that sells its entire interest in an opportunity fund and invests the proceeds in a new opportunity fund within 180 days of the date on which the prior gain would be includible in income (but not later than Dec. 31, 2026) can continue to defer tax on the gain with respect to the original property. A taxpayer that sells only a portion of its investment in an opportunity fund cannot continue to defer gain. The availability of certain tax benefits of investing in an opportunity fund depends upon the taxpayer’s holding period. The Proposed Regulations do not indicate whether a taxpayer is permitted to tack its prior holding period on to its holding period for its new opportunity fund investment in order to enjoy these benefits. Accordingly, it is unclear whether an investor can continue, or must restart, its holding period for purposes of determining the investor’s eligibility for the statutory 5-, 7- and 10-year basis-step ups.
Types of Taxpayers Eligible to Elect Gain Deferral. Under the Proposed Regulations, individuals, C corporations (including regulated investment companies and real estate investment trusts, partnerships, common trust funds, qualified settlement funds, and disputed ownership funds are eligible for deferral. If a partnership does not elect deferral, partners in that partnership may elect deferral under special rules for pass-through entities. Analogous rules apply to S corporations, estates and trusts. The IRS has requested comments regarding whether the special rules for partnerships and other flow-through entities are sufficient.
Only Equity Investments Can Qualify. Under the Proposed Regulations, only equity (including preferred stock and partnership interests with special allocations) in an opportunity fund entitles the taxpayer to deferral of tax on gain with respect to the original property. A taxpayer that invests in a debt instrument issued by an opportunity fund does not qualify for deferral. The equity interest in an opportunity fund can be used as a collateral for a loan without jeopardizing the taxpayer’s deferral.
Attributes of Deferred Gains Are Preserved. By statute, the deferred gain is included in income no later than Dec. 31, 2026. The Proposed Regulations provide that all of the deferred gain’s tax attributes are preserved. The Proposed Regulations provide a first-in first-out (FIFO) method for recognizing gain if a taxpayer sells less than all of its interest in an opportunity fund prior to Dec. 31, 2026 and does not reinvest the proceeds in another opportunity fund.
Availability of Exclusion After Opportunity Zones Expire. The statute permits a taxpayer that holds an interest in an opportunity fund for 10 years or more to elect to step up its basis in its interest in the fund and avoid all tax with respect to appreciation on its interest in the fund. However, the designation of opportunity zones expires no later than Dec. 31, 2028. The Proposed Regulations provide that the ability to make the 10-year basis step up election is available until Dec. 31, 2047. Accordingly, it appears that the only consequence of the expiration of the opportunity zone designation is that new investments made after Dec. 31, 2028 will not be considered zone business property. The IRS has requested comments on this rule.
Opportunity Funds Can Be Organized as LLCs. Under the Proposed Regulations, any entity classified as a partnership or corporation for federal tax purposes, including a limited liability company (LLC), is eligible to be an opportunity fund. A list of frequently asked questions published by the IRS clarifies that an LLC that is treated either as a partnership or corporation for federal tax purposes can organize as an opportunity fund.
Self-Certifications for Opportunity Funds. The Proposed Regulations permit zone corporations and zone partnerships (zone entities) to self-certify that they meet the requirements to be treated as opportunity funds. The IRS released draft Form 8996 concomitantly with the Proposed Regulations Zone entities that desire to be treated as opportunity funds must include this form with their regular tax returns. See Instructions for Form 8996 (Rev. December 2018).
Effective Date of Proposed Regulations. The Proposed Regulations generally are proposed to be effective on or after the date of publication of final regulations. Nevertheless, taxpayers and opportunity funds may rely on a number of the rules in the Proposed Regulations, so long as the taxpayer and/or the opportunity fund applies the Proposed Regulations in their entirety and in a consistent manner.
U.S. investors currently hold trillions of dollars in unrealized capital gains in stocks and mutual funds alone— a significant untapped resource for economic development. Funds will enable a broad array of investors to pool their resources in Opportunity Zones, increasing the scale of investments going to underserved areas.
WHAT ARE THE INCENTIVES THAT ENCOURAGE LONG-TERM INVESTMENT IN LOW INCOME COMMUNITIES? Opportunity Zones offer investors the following incentives for putting their capital to work in low-income communities:
- A temporary tax deferral for capital gains reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the date on which the opportunity zone investment is sold or December 31, 2026.
- A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis of the original investment is increased by 10% if the investment in the qualified opportunity zone fund is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years, excluding up to 15% of the original gain from taxation.
- A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund, if the investment is held for at least 10 years. (Note: this exclusion applies to the gains accrued from an investment in an Opportunity Fund, not the original gains)
An investor will need to invest in an Opportunity Fund by the end of 2019 in order to meet the seven-year holding period and be able to exclude 15% of the deferred capital gain. An investor may exclude 10% of the deferred capital gain by investing in an Opportunity Fund by the end of 2021 in order to meet the five-year holding period.
– The program differs markedly from past tax incentive programs designed to improve low-income communities. It is market-driven, does not require impact reporting, and focuses on equity investments as opposed to traditional programs which focus on debt. And—because there is no cap to the number of Opportunity Funds that can be created nor limit to the total dollars that can be invested, Opportunity Zones have the potential to become the largest community development program in our nation’s history. Still, there’s much uncertainty about how much investment will flow into Opportunity Zones, what those investments will look like, and how they will impact people’s lives.