As part of the Tax Cuts and Jobs Act of 2017 (the TCJA), Congress added new rules to the Internal Revenue Code intended to promote investments in low-income communities designated as “qualified opportunity zones.” New IRC sections 1400Z-1 and 1400Z-2, effective December 22, 2017 (the OZ Program) quickly caught the eye of long-term investors by offering some unique tax incentives:
- Tax deferral for gains on virtually any asset sold where the gain is timely reinvested into a qualified opportunity fund (Opportunity Fund), a partnership or a corporation formed for the purpose of investing in qualified opportunity zones (QOZs);
- Ability to redeploy capital with fewer restrictions, since only the gain needs to be rolled into the Opportunity Fund, not the entire sales proceeds;
- The potential to eliminate tax on a portion of those gains by staying invested in the Opportunity Fund for five or more years; and
- The elimination of tax on any appreciation in the investment in the Opportunity Fund if such investment is held at least 10 years.
The tax benefits are intended to attract long-term capital investments into economically challenged areas. The law instructs the Secretary of the Treasury to prescribe regulations to carry out the OZ Program. Although we await the Treasury’s proposed regulations, investors should not wait to familiarize themselves with the basic structure, requirements and incentives of the OZ Program.
OZ Program Overview
The law required the states’ governors (and the mayor of Washington DC) to designate a specified number of QOZs and submit them to Treasury for certification within a short time period following enactment of the TCJA. Treasury released an initial list of QOZs in April and certified its final list in June in IRS Notice 2018-48. (The QOZs can also be viewed on a map.) These QOZs will retain this designation for 10 years, until the end of 2028.
Eversheds Sutherland Observation: Eligible census tracts were primarily those meeting established “low-income community” criteria. The new law, however, permitted the designation of a limited number of tracts contiguous with a low-income community and meeting other qualifying criteria. And each state had essentially unlimited discretion to designate QOZs meeting the eligibility criteria. The QOZs resulting from this process encompass a broad range of geographic, demographic and economic profiles and thus a wide array of investment opportunities.
The OZ Program offers investors both immediate and potential future tax benefits. An investor that would otherwise recognize gain on the sale of property to an unrelated third party (defined by reference to IRC sections 267(b) and 707(b)(1), but with a 20% ownership threshold) may elect NOT to include in gross income so much of such gain as is invested in an Opportunity Fund within 180 days following such sale.
Eversheds Sutherland Observation: The final version of the new law refers to gain from the sale or exchange of “any property.” This appears to encompass not only “capital assets,” but also property used in a trade or business and other categories of property. Less clear are:
- Whether depreciation recapture can also be deferred;
- Whether a partner or an S corporation shareholder can elect to defer its distributive share of gain recognized by a partnership or S corporation (unlikely based on the statutory language, but arguably consistent with policy objectives); and
- Whether Treasury will choose to clarify these scope issues in future regulations.
Taxable Income Deferred, Reduced, Eliminated
Gain that is excluded from income and rolled into an Opportunity Fund is recognized on the earlier of the date on which the taxpayer’s investment in the Opportunity Fund is sold or exchanged, or December 31, 2026. The amount of gain recognized on such date is the excess of (i) the amount of gain that was deferred from the original sale or exchange (or, if less, the fair market value of the investment in the Opportunity Fund on the recognition date), over (ii) the taxpayer’s basis in the investment.
Eversheds Sutherland Observation: Because the OZ Program rules incentivize a long-term hold, investors seeking the full benefits of the OZ Program will hold their investment in an Opportunity Fund beyond the December 31, 2026 date, which may result in a 2026 tax liability without a corresponding liquidity event to provide the funds to pay those taxes. Investors in Opportunity Funds should plan accordingly.
The taxpayer’s basis in its investment in the Opportunity Fund is deemed to be zero, but that’s where the second tax incentive kicks in. If the investment in the Opportunity Fund is held for at least five years, the tax basis in the investment is increased by 10% of the amount of the deferred gain; if the investment is held at least seven years, there’s another basis increase of 5% of the deferred gain.
- Thus, a taxpayer with a 2018 gain that is rolled into an Opportunity Fund may be able to defer any gain recognition for up to eight years, and up to 15% of the gain will have escaped taxation entirely if the investment in the Opportunity Fund is held at least seven years.
- Further, only the gain was required to be rolled into the Opportunity Fund, not the entire sales proceeds. Contrast, for example, like-kind exchanges, in which gain is currently taxable to the extent of cash or non-like kind property (“boot”) received. So, a taxpayer can choose to cash out the “basis portion” of its prior property investment and deploy those funds elsewhere.
- Although not required, a taxpayer may invest more than the amount of its deferred gain into an Opportunity Fund. In that case, the special OZ Program tax rules (including the 10-year rule described below) will apply only to the portion of the investment representing the deferred gains; any excess amount is effectively treated as an investment in a parallel fund for tax purposes. Other OZ Program rules, including those governing the investments an Opportunity Fund can and must make (summarized below), apply to the entire fund.
The taxpayer’s basis in its investment in an Opportunity Fund is increased by the amount of gain recognized under these rules. The third incentive arrives if the investment by the taxpayer in the Opportunity Fund is held at least 10 years. In that event, the basis of the investment is equal to its fair market value on the date it is sold or exchanged.
- This basis step-up should effectively allow a taxpayer to eliminate tax on any appreciation in the value of its investment in the Opportunity Fund. Because a 10-year hold that begins no earlier than 2018 will necessarily extend past December 31, 2026, the taxpayer will already have recognized the deferred gain on the previous sale (as adjusted by the basis increases at five and seven years) and received a corresponding step-up in basis.
- The rules do not directly eliminate the recognition of income, gain or loss on the investments within the Opportunity Fund. In a typical partnership structure, therefore, the rules effectively incentivize a long-term “invest and hold” strategy—and probably single-asset Opportunity Funds.
The following example illustrates the general operation of these rules.
Eversheds Sutherland Observations: The interaction of the special OZ Program tax rules and the partnership basis adjustment rules is not clear in a number of respects. Perhaps regulations will provide needed guidance and certainty. Also, a literal application of the statute reveals the possibility of a “step-down” in basis under the 10-year rule under certain circumstances–a result that seems inconsistent with Congressional intent. It will be interesting to see whether Treasury tries to remedy that “glitch” or whether taxpayers will need to be vigilant as investments approach the 10-year anniversary and possibly consider self-help measures if they otherwise could be adversely impacted.
Finally, the exit from an Opportunity Zone investment appears to require a taxable disposition of the interest in the Opportunity Fund, rather than a more typical disposition of the Fund’s assets. This seems workable only for single-asset Opportunity Funds or if Treasury allows dispositions to related parties that essentially allow a taxpayer to mark to market its investment tax-free.
Opportunity Funds – Real Estate Development May Be the Leading Edge
To qualify as an Opportunity Fund for the OZ Program, a corporation or a partnership must be formed for the purpose of investing in certain qualified stock, partnership interests and tangible property used in a trade or business of the Opportunity Fund (QOZ Property), and must hold at least 90% of its assets in QOZ Property, measured twice a year. While the QOZ Property definition covers a variety of possible business investments to be made within a QOZ, it has not been lost on real estate developers and investors that the geographically focused nature of the program lends itself naturally to investment in the development and redevelopment of real estate located within an Opportunity Zone.
In addition to being located in a QOZ and acquired by an Opportunity Fund by purchase after December 31, 2017, to be QOZ Property, real property must be developed or substantially improved by the Opportunity Fund. To be “substantially improved” by an Opportunity Fund, during any 30-month period beginning after the date of acquisition of the property, additions to basis with respect to such property must exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period.
Eversheds Sutherland Observation: Based on the magnitude of the required additions to basis, it is likely that the only real estate investments that would qualify as QOZ Property would be ground-up developments or significant redevelopments, as opposed to investments in existing properties or value-add investments.
Opportunity Funds – Other Investments
Opportunity Funds are not limited to investing in real estate development projects. An equity investment in a corporation or a partnership conducting a “qualified opportunity zone business” can qualify, as can investments in tangible personal property used in such a business. The rules for such investments are detailed but generally consistent with Congress’s intention to incentivize new investments in QOZs. Given the wide array of opportunities, it will be interesting to see if commingled investment funds emerge that invest significant funds in both QOZ real estate projects and other qualifying businesses or if more targeted efforts predominate.
Investors and developers alike have indicated substantial interest in the OZ Program, and eagerly await the issuance of regulations by Treasury.