By: Michael Jakimzak, Senior Tax Manager
One very beneficial piece of the Tax Cuts and Jobs Act legislation, the Federal Opportunity Zone Program, has flown under the radar. This new program was designed to incentivize private capital investment in businesses located in economically distressed areas by providing capital gain deferrals, basis step-ups and a potential permanent exclusion on the appreciation of these investments. Following is a general overview of the program and the tax benefits available to those looking at investing into these economically distressed areas.
WHAT ARE OPPORTUNITY ZONES?
Opportunity Zones are economically-distressed communities. Specific zones are based mostly on census tracts and are nominated by states for approval by the Treasury. Lists and maps of the zones designated thus far are available at this website: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
WHAT ARE THE BENEFITS?
Taxpayers can defer the recognition of capital gains by reinvesting the gain into a Qualified Opportunity Fund. The deferred gains are taxable when the investment is sold or, if earlier, on December 31, 2026. Note that if a taxpayer still holds the investment on December 31, 2026, they will be required to recognize the deferred gain as of this date.
If an Opportunity Zone investment is held for 5 years prior to December 31, 2026, 10% of the deferred gain is excluded from income. If the investment is held for 7 years, an additional 5% of the deferred gain is excluded. Due to the mandatory inclusion date of December 31, 2026, an Opportunity Zone investment must be made by December 31, 2019 to qualify for the maximum 15% reduction of the deferred gain.
In addition to the possible reduction of the deferred gain mentioned above, if the investment is held for at least 10 years, the gain on appreciation in excess of the original investment can be eliminated through a full step-up in basis to fair market value. In other words, no tax will be paid on the appreciation of the Opportunity Zone investment if held for at least 10 years.
If the taxpayer invests more into a qualified fund than the gain from a sale they wish to defer, the investment in the qualified opportunity fund is treated as two separate investments and the deferral rules would only apply to the investment with respect to the gain which is deferred.
HOW DOES IT WORK?
In order to recognize the benefits of the Opportunity Zone Program, a taxpayer must sell an existing investment and realize a capital gain. If the proceeds of the sale are reinvested into a Qualified Opportunity Fund within 6 months of the sale, the taxpayer can elect to defer the gain until the new investment is sold or, if earlier, on December 31, 2026.
A Qualified Opportunity Fund is defined simply as an investment vehicle that is organized as a partnership or corporation for the purpose of investing in Qualified Opportunity Zone Property. To qualify as a Qualified Opportunity Fund, 90% of the fund’s assets must be invested in Qualified Opportunity Zone Property. A fund is self-certified and must attach a form to their tax return to identify as such.
Qualified Opportunity Zone Property is corporate stock, partnership interests, or business property as long as the aforementioned assets are acquired with cash after December 31, 2017 and the businesses are Qualified Opportunity Zone Businesses. A qualified business is a trade or business in which substantially all of the tangible property is Qualified Opportunity Zone Business Property. Qualified Opportunity Zone Business Property is property purchased after December 31, 2017 where substantially all of the use of such property is in a qualified opportunity zone.
In the case where the original use of the business property does not begin with the Qualified Opportunity Fund, the fund must substantially improve the property. Substantial improvement is defined as capital improvements that exceed the adjusted basis of such property within any 30-month period beginning after the date of the acquisition of the property. In real estate, for example, if an existing apartment complex is purchased for $5M, the fund would have to spend an additional $5M within 30 months in order for the property to be considered substantially improved and, therefore, Qualified Opportunity Zone Business Property. In-line with the program’s policy goals of stimulating development in these areas, a Qualified Opportunity Fund may be best suited for real estate developers rather than owner-operators.
Note that this is a federal incentive and the zones exist in almost every state; there is no requirement that the taxpayer reinvest in their home state. Also, be aware that not all states conform to the new tax law (California does not), so there may not be gain deferral at the state level.
Opportunity Zones can be a very valuable tool to defer capital gains, and can also provide permanent tax deferrals in some situations. There are many requirements in order to qualify for these tax incentives, and there are still many areas in the legislation that need further clarification from the Treasury Department and the Internal Revenue Service. If you are interested in hearing more about this opportunity, please reach out to one of our firm’s tax professionals to discuss.
Please contact Michael Jakimzak at 415.624.2261 to discuss in detail.