The Federal tax reform bill passed at the end of 2017 made voluminous changes to the Federal tax code, but one relatively small section has potentially drawn more attention than any other, attracting the likes of real estate developers, investors, investment advisors, municipal leaders, accountants, lawyers and many, many others. Sections 1400Z-1 and 1400Z-2 of the reformed Internal Revenue Code have created “opportunity zones”—i.e., designated tracts of economically distressed areas found in all 50 states, D.C. and five territories—for the purpose of incentivizing investment in these areas by dangling opportunities to defer and, in some cases eliminate, taxes on realized capital gains. If investors take the gains they’ve realized on the sale or disposition of any capital assets, invest in a “qualified opportunity fund” within certain time limits, and hold their interests in that fund for certain specified time periods, they could potentially recognize the following benefits:
Federal income tax deferral until the earlier of the disposition of an interest in the qualified opportunity fund or December 31, 2026;
- A 10% reduction in tax if the interest in the qualified opportunity fund is held for 5 years;
- Another 5% reduction in tax if the interest in the qualified opportunity fund is held for 7 years; and
- No tax on any appreciation in the investment in the qualified opportunity fund if the interest is held for 10 years and then disposed of in a taxable transaction.
These benefits are available to any domestic taxpayer, but there is a gauntlet of rules and restrictions that must be carefully followed in order to qualify for these tax benefits. For example:
- Capital gains must be invested into a qualified opportunity fund within 180 days of the realization of such gains;
- 90 percent of the assets of a qualified opportunity fund must be tangible property within an opportunity zone;
- Qualified opportunity funds must self-certify as such with the IRS;
- Qualified opportunity funds must measure their asset percentage six months after their election and at the end of the year, using the average to determine whether they qualify for the 90-percent test;
- Qualified opportunity funds must continue to measure their asset percentage annually; and
- Tangible assets, other than land, acquired in an opportunity zone must be “substantially improved” through investments in excess of the fund’s basis within any 30 month period.
There are many more subtle rules in the statutes and proposed regulations that will require proper care when forming a qualified opportunity fund or investing through one. There are also some transaction structures that can be more favorable than others. Specifically, if a qualified opportunity fund makes an investment in a partnership or corporation that has an active trade or business in the opportunity zone, the proposed regulations provide that such lower tier “qualified opportunity zone business” can provide much-needed relief not available to a qualified opportunity fund that invests directly in tangible property in an opportunity zone. For example, such a structure only requires such a qualified opportunity zone business to hold 70% (rather than 90%) of its assets in tangible property in the opportunity zone. In addition, the proposed regulations provide for a “working capital safe harbor” that could allow a qualified opportunity zone business to draw up a written working capital plan and deploy the cash it receives from the qualified opportunity fund over a period of 31 months (rather than by averaging the asset percentages after six months and at the end of the year with a direct investment).
Despite all of these rules and restrictions, there are even more unanswered questions that exist due to the relative lack of guidance that has been issued since the end of 2017. Only proposed regulations issued in October 2018 and one revenue ruling have been issued thus far. More guidance is expected in the coming weeks and months, but navigating these waters can be challenging. If you are interested in learning more about how to take advantage of the tax benefits available, we would appreciate the opportunity to discuss them with you.