How will the United States recover from the COVID-19 pandemic? At least part of the answer may be by making a few critically important tweaks to the Opportunity Zone tax incentives contained in Code Section 1400Z-2 (the “OZ Act”).
The OZ Act was specially designed to promote economic development in targeted locations, and so it is a natural tool for Congress to use as it seeks to promote a nation-wide business recovery. Many of us who have been active in the OZone world have discussed ad nauseum how to modify the OZ Act so that it can be used both to accelerate relief for distressed communities in designated opportunity zones and to help small businesses whose fortunes have been decimated by the effects of the COVID–19 pandemic.
Two members of the House of Representatives from opposite sides of the aisle, John Curtis R – Utah and Henry Cuellar, D – Texas, have introduced a bill entitled “COVID-19-Impacted Small Business Opportunity Zone Act” (“SBOZA”), which would extend the benefits of the OZ Act to “qualified small businesses,” while also proposing a handful of modifications that, if adopted, would dramatically enhance the ability of the OZ Act achieve its public-policy objectives.
The SBOZA would modify existing law in four critical areas:
1. Small Businesses Affected by Covid-19. A new category – Qualified Small Businesses – would be accorded the status of Qualified Opportunity Zone Businesses (“QOZBs”) without needing to be located in a designated opportunity zone. Thus, investors in these businesses through Qualified Opportunity Funds (“QOFs”) would be eligible for the tax benefits under the OZ Act.
A “Qualified Small Business” is any trade or business whose gross receipts for the relevant taxable year does not exceed $999,999, (i.e., truly “small” businesses with under $1 million in annual gross receipts), if such business has experienced certain broadly defined adverse effects as a result of the spread of, or the public’s or any government’s response to, COVID-19. The definition of “relevant tax year” which contains two apparent drafting errors -- “means the last taxable year which ends before the date on which the qualified opportunity zone fund [sic] acquires the qualified opportunity fund property [sic] to which the trade or business relates.” (Based on the context of the proposed legislation, one could conclude this means the date on which a QOF invests in “qualified opportunity zone property,” i.e., a Qualified Small Business. However, this language will probably need to be clarified when and if the Congress moves forward with this legislative proposal.) By limiting these expanded benefits to investments made in the one-year period beginning on the date of enactment, the SBOZA is designed to push money quickly into Qualified Small Businesses.
2. Application of Capital Gains Tax Rate for Taxable Year in Which Investment Is Acquired. The tax rate on deferred gain invested in a QOF would be set at the capital gains rate for the tax year in which the investment is made (meaning presumably the tax year in which the deferred gain was originally recognized, but again clarification would be much appreciated). Currently, the law requires deferred gain to be included in income no later than 2026 and tax paid at the capital gains tax rate then applicable.
Even before COVID-19, many potential investors were understandably concerned that tax rates in 2026 might be materially higher than the current rates, and that deferring recognition of gain to 2026 could be a detriment rather than a benefit. The explosion of federal government spending to address the Covid-19 Emergency has, if anything, exacerbated these well-founded concerns that future tax rates might need to be raised to pay for all this emergency spending.
It is axiomatic that investors like certainty. Fixing the tax rate at the current level satisfies those concerns.
3. Extension of Deferral of Gain Invested in Opportunity Zones. One of the tax incentives in the OZ Act was that an investment held for seven years or more would enjoy a basis adjustment, which in effect reduced the tax payable on the original invested gain. But, what was an incremental 5% basis adjustment for investments held for more than five years but less than seven years is no longer available under the OZ Act as currently in effect because gain needed to be invested by December 31, 2019 in order to qualify for a full seven-year holding period to the outside inclusion date of December 31, 2026.
The SBOZA would defer the outside inclusion date of deferred gain beyond December 31, 2026 to the date that is seven years after the day “on which the investment is acquired.” This allows new investors (those who invest after the enactment of the SBOZA) to enjoy the full palette of tax benefits originally available under the OZ Act, including a full 15% basis adjustment and a deferral for a full seven tax years (although it truly measured from the investment date, the deferral would often be at least eight tax years). Of course, dispositions sooner than seven years would result in earlier recognition of income.
4. Exemption From Tax for Investments Held for at Least 10 Years Without Regard to Whether the Investment Consists of Reinvested Gain. The OZ Act currently rewards only taxpayers who invest capital gain, and a non-capital gain cash investment, while permitted, does not enjoy any of the OZ tax incentives. Of course, those non-gain investors do not need a subsequent basis adjustment, nor do they worry about the tax rate payable on gain in the inclusion year because they are not investing gain or deferring payment of tax on gain.
The OZ Act encouraged taxpayers with existing built-in gain to recognize that gain and then re-invest it in opportunity zones. The logic of making such a major tax distinction between “gain dollars” and “regular dollars” was never particularly compelling –the goal, after all, was to drive investment of any kind of dollars into opportunity zones. The SBOZA provides that non-gain dollars would now be eligible for the crown jewel of the tax incentives under the OZ Act, which is the ability to exclude the gain on investments held for at least 10 years from income. The SBOZA does this by giving this tax benefit to “any investment in a qualified opportunity fund” without regard to whether the funds invested are capital gain. Investment of gain would still enjoy the deferral and basis-adjustment benefits under the OZ Act, but the distinction between gain and non-gain is significantly reduced.
As with all legislation, the effective date is important. The SBOZA recites that amendments to the OZ Act apply to investments made in QOFs after the date the SBOZA is enacted (i.e., only apply to property acquired by the QOF after the enactment date.)
Who knows whether the SBOZA will ever be enacted? The fact that it has been proposed is clear evidence that our representatives are trying to accelerate the recovery we all need by expanding the scope of the OZ Act.