The Tax Cuts and Jobs Act passed last year contains an important new set of tax-advantaged investment incentives – Opportunity Zones. Although estimates vary, Opportunity Zones are projected to attract at least $10 billion in investments annually for the program’s 10-year life.
The main idea is to promote economic activity in Opportunity Zones through investment in Qualified Opportunity Funds (QOFs).
If a capital gain is invested in a QOF, the tax due on the gain is deferred until the earlier of the sale of the QOF or 12/31/26. If the investment is held for at least 5 years, the amount of the gain to be taxed will be reduced by 10%, and if the investment is held for at least 7 years, the amount of the gain to be taxed will be reduced by an additional 5%.
If the QOF is held for 10 years, the taxpayer’s basis in the QOF is stepped up to the fair market value of the QOF at the time of its sale. In other words, any appreciation in value of the QOF is tax exempt. This benefit is separate from the capital gains deferral – the tax on deferred capital gains will be due by 12/31/26 at the latest even if the investment in the QOF is being held past that date in order to qualify for the 10-year exemption.
Taxpayers that can use QOFs to defer gain include individuals, C corporations (including RICs and REITs), partnerships, S corporations and other pass-through entities (trusts and decedents’ estates).
Any eligible taxpayer can form a QOF – it can be any size and the process is self-certifying, so no government approvals are needed.
While the regulations will not be issued in final form until after a notice and comment period, the proposed regulations may be relied on immediately by taxpayers who apply the proposed regulations in their entirety on a consistent basis.
The investment in the QOF must be made within 180 days of the sale giving rise to the capital gain.
A partnership may elect to defer capital gains, but if it does not do so, a partner in the partnership may elect separately to defer capital gains allocated to the partner. There does not need to be a cash distribution from the partnership for the partner to elect deferral and make a QOF investment. A partner’s 180-day period generally begins on the last day of the partnership’s taxable year.
If the investment in the QOF is sold for less than the capital gain being deferred, capital gains tax will be due only on the proceeds received from the sale.
The election to increase basis in the QOF investment to its fair market value at the time of sale (after the QOF investment has been held for 10 years) may be made until 12/31/47.
LOCATION OF OPPORTUNITY ZONES
Opportunity Zones are census tracts in low-income communities (or adjacent in certain circumstances) designated by the governor of each state – there are designated tracts in every state plus PR and some of the territories.
The Community Development Financial Institutions Fund of the Treasury Department provides resources on Opportunity Zones. Click here to view the map of the opportunity zones and a state-by-state spreadsheet list.
- There is a map link on that page – follow the instructions there by clicking on the “Layers” tab on the menu on the right side of the screen, select “Opportunity Zone Tract” and unselect “2011-2015 LIC Census Tract” and zoom in to a specific area on the map. The Opportunity Zones will appear in blue.
The definition of low-income community is one with a poverty rate of at least 20% or median family income that does not exceed 80% of the greater of statewide median family income or metropolitan area median family income (but just statewide measure for communities outside of metropolitan areas).
The Opportunity Zone designation is for 10 years – all current OZ designations will expire on 12/31/28.
A QOF can be either a partnership or a corporation. The QOF must invest in one of 3 ways:
- Investment in a partnership (or LLC)
- Investment in a corporation
- Investment in tangible property
The investment in a QOF must be an equity interest, including preferred stock or a partnership interest with special allocations.
The partnership or corporation must be organized to operate in an Opportunity Zone. Tangible property must be used by the QOF in an Opportunity Zone.
To be a Qualified Opportunity Zone (QOZ) business, substantially all of the tangible property owned or leased by the taxpayer must be QOZ business property. QOZ business property must be acquired after 12/31/17, the original use of the property begins with the QOF or the QOF substantially improves the property, and substantially all of the use of the property is in a QOZ during the holding period.
“Substantially improves” means if during any 30-month period beginning after the date of the acquisition of the property, additions to basis of property are greater than the adjusted basis of the property at the beginning of the period. The adjusted basis of the property refers only to tangible property (including any existing building and other improvements) – land is excluded from the calculation.
MINIMUM INVESTMENT REQUIREMENTS
The QOF must have 90% of its assets invested in QOF property. However, cash may be held for up to 31 months if there is a written plan satisfying the requirements of a working capital “safe harbor” demonstrating that the financial assets will be used in the acquisition, construction, or substantial improvement of tangible property in the OZ.
If an entity qualifies as a QOZ business, the value of the QOF’s entire interest in the entity counts toward the QOF’s satisfaction of the 90% test.
For an entity to qualify as a QOZ business, substantially all of its tangible property must be QOZ business property. “Substantially all” is defined in the proposed regulations as 70% of the tangible property owned or leased by the entity.
In other words, it is possible for as little as 63% of an investment in a QOF to be deployed in a QOZ business (70% of 90%) but still have the entire amount of the investment in the QOF qualify for the deferral and exclusion benefits.
ROLLING OVER INVESTMENTS
If an investment in a QOF is sold before 12/31/26, the deferral may be continued if a new QOF investment is made within 180 days of the sale of the original QOF investment.
The deferral is elected by attaching new Form 8949 to the taxpayer’s return.
The QOF certification is made by the taxpayer filing new Form 8996 (Qualified Opportunity Fund) with its tax return and annually thereafter.