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We’ve received numerous inquiries regarding the qualified opportunity zone (“Opportunity Zones”) program created by the recently passed Tax Cuts and Jobs Act (“TCJA”).[1]  In response, we’ve compiled the following alert discussing:

(i) the current status of the program;

(ii) structuring qualifying investments; and

(iii) tax benefits of Opportunity Zone investments.  

Importantly, while the TCJA established a general framework for Opportunity Zones, this framework more closely resembles an initial outline than a finished product.  Therefore, the Treasury Department must promulgate final rules defining how and when qualified investments may commence. We will provide an update when this occurs.

Background

At least one economic research study estimates that U.S. citizens and companies held over $6 trillion in unrealized capital gains in 2017.[2]  In an effort to recirculate that vast pool of capital back into the economy, particularly in distressed communities, the Opportunity Zone concept was initially proposed by the Investing in Opportunity Act[3] introduced by a bi-partisan coalition of U.S. Representatives and Senators in 2016. The legislation was adopted and passed into law on December 22, 2017 as part of the TCJA. Though somewhat overshadowed by other provisions of the TCJA at the time, Opportunity Zones are beginning to generate enthusiasm as a potentially powerful economic development tool to incentivize investment in low income communities by providing investors with meaningful deferral and partial permanent exclusion of unrealized capital gains.  We await further guidance from the Treasury Department as to the exact mechanics of the program.

Qualified Investments

The Opportunity Zone program aims to facilitate the flow of long-term capital to low-income communities. These low-income communities are designated as Opportunity Zones, which are low-income census tracts, not to exceed 25% of qualifying low-income census tracts, nominated by each state’s governor and confirmed by the Treasury Department.[4] Investments may be made into companies, projects, business equipment and commercial property located within Opportunity Zones (collectively, “Opportunity Zone Property”) by providing tax advantageous treatment to qualifying investments. These tax benefits (discussed in more detail below) include deferral of existing unrealized capital gains, a partial step-up in adjusted basis in the capital asset underlying such gains, and permanent tax exemption on any appreciation of Opportunity Zone investments. 

Importantly, investors will be required to invest in Opportunity Zone Property through a qualified opportunity fund (an “Opportunity Fund”). An Opportunity Fund can be “any investment vehicle organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property,”[5] which must comprise at least 90% of its assets.[6] This 90% threshold is tested at the end of the first 6 month period of the Opportunity Fund’s taxable year and then on the last day of each subsequent taxable year. To become an Opportunity Fund, an eligible taxpayer self certifies by filing a form[7] with its federal tax return. This is in contrast with the New Markets Tax Credit (“NMTC”) program, which channels investment through specialized financial intermediaries known as Community Development Entities (“CDEs”). Further, pending final rules from the Treasury Department, there is no limit on the total amount of eligible Opportunity Zone investment.

Tax Benefits

Opportunity Zones offers three primary tax benefits to potential investors:

1. Temporary deferral of inclusion in taxable income for capital gains reinvested into an Opportunity Fund.
2. Step-up in basis for capital gains reinvested in an Opportunity Fund. The adjusted basis is increased by 10% if the Opportunity Fund investment is held for at least 5 years and by an additional 5% if held for at least 7 years, thereby excluding up to 15% of the re-invested capital gain. The deferred gain, subject to any step-up in basis, must be recognized on the earlier of the date on which the Opportunity Zone investment is disposed of or December 31, 2026 (the “Deferred Gain Recognition Date”).
3. A permanent exclusion from capital gains tax on the sale or exchange of an Opportunity Fund investment if the investment is held for at least 10 years. This exclusion applies only to gains accrued during the Opportunity Fund investment.

To qualify, investors must reinvest the amount of capital gain in an Opportunity Fund within 180 days after the date of sale of the underlying capital asset. The IRS recently clarified that sales of capital assets in the 2017 tax year are eligible for Opportunity Zone treatment if a qualifying investment is made within the 180-day timeframe. That would make June 29, 2018 the deadline to make a qualifying investment, assuming the preceding exchange occurred on the last day of 2017.

In order to receive the total 15% step-up in basis of the re-invested capital gain, which requires a full 7-year holding period before the Deferred Gain Recognition Date, investors must make a qualifying investment by December 31, 2019. To receive the initial 10% step-up in basis of the re-invested capital gain, which requires a 5-year holding period before the Deferred Gain Recognition Date, investors must make a qualifying investment by December 31, 2021.

Next Steps

Opportunity Zones offer a potentially powerful economic development tool for underserved communities by creating an attractive investment opportunity for investors. The partial step-up in basis and exclusion of future appreciation seem to present a compelling alternative to “like-kind” exchanges under Section 1031 of the Internal Revenue Code for investors seeking to defer unrealized capital gains. Opportunity Zones also may supplement NMTCs to incentivize investment in low income communities if Opportunity Funds and CDEs can work together effectively. Further, municipal governments could enhance the attractiveness of investment within their jurisdiction by offering local incentive programs that piggyback on Opportunity Zone investments.

While the Opportunity Zone program appears promising, its full scope and impact will not be known until the Treasury Department issues final rules. We plan to update this information as additional guidance becomes available. Please don’t hesitate to contact us in the interim with any specific questions about Opportunity Zones. We look forward to working with you to develop an individualized solution to achieve your business objectives.

If you have any questions, please contact Jason A. Butterworth (jabutterworth@bmdllc.com) or Kevin Saunders (rksaunders@bmdllc.com).

 

[1] 26 U.S.C. § 1400Z—1.

[2] See Economic Innovation Group, Opportunity Zones Tapping into a $6 Trillion Market, http://eig.org/news/opportunity-zones-tapping-6-trillion-market (last updated March 21, 2018).

[3] S.2868 — 114th Congress (2015-2016).

[4] For all currently designated Opportunity Zones in the U.S.: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx; for Ohio’s designed Opportunity Zones: https://development.ohio.gov/bs/bs_censustracts.htm; for Florida’s designated Opportunity Zones: https://deolmsgis.maps.arcgis.com/apps/webappviewer/index.html?id=4e768ad410c84a32ac9aa91035cc2375.

[5] 26 U.S.C.A. §1400Z-2(c)(5); I.R.C. §1400Z-2(c)(5).

[6] 26 U.S.C.A. §1400Z-2(d)(5); I.R.C. §1400Z-2(d)(5).

[7] The IRS will publish the required form this summer. https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions.