The Tax Cuts and Jobs Act of 2017 (TCJA) introduced “opportunity zones,” a new incentive to spur investment in low-income communities. The new law shares some similarities with other incentives by focusing on specific disadvantaged geographic areas, but unlike other programs that provide tax credits or accelerated deductions for making investments or creating jobs in distressed areas, the opportunity zone program offers tax deferral and exclusion to attempt to drive investment into such communities by unlocking gains from investors’ portfolios.
To realize the benefits of the program, investments must be made into a new type of investment vehicle known as a “qualified opportunity fund” (QOF). It’s important for real estate developers that are considering projects in designated opportunity zones and for investors that are considering investing in such projects to understand the program so that they can take advantage of its benefits.
What you get
Opportunity zones allow taxpayers to defer and possibly exclude gains from taxable income, as follows:
- Tax benefits applicable to asset sales used to fund investments in QOFs:
- Deferral of gain until Dec. 31, 2026, (or until the sale of the QOF, if earlier)
- Exclusion of 10 or 15 percent of gain if QOF is held five or seven years when deferred gain is recognized
- Gain must be reinvested in QOF within 180 days
- Tax benefit applicable to gains from the sale of an interest in a QOF
- 100 percent exclusion of gain
- Investment in QOF must be held for at least 10 years
How you get it
In order to qualify for the tax deferral and exclusion offered under the new law, taxpayers need to take the following steps:
- Verify the project is in a "qualified opportunity zone" (QOZ). A list of approved QOZs can be found on the Opportunity Zones Resources page of the CDFI Fund’s website.
- Reinvest gain into a QOF within 180 days. The tax benefits associated with investing in QOFs are only available to the extent that the investment is funded from the proceeds of gains within 180 days. Investments in QOFs that exceed the investor’s gains within 180 days are not eligible for any of the deferral or exclusion benefits. In contrast to Section 1031 Like-kind Exchanges, the opportunity zone program does not require the use of an intermediary and only the gain (versus proceeds) is required to be reinvested.
- Self-certification of QOF. For most real estate projects, the QOF will either be the partnership that owns the project or an upper-tier partnership in the ownership structure. Such partnership will be required to self-certify as a QOF by completing and attaching a tax form to its timely filed tax return. This type of certification is not an application that the IRS is required to approve.
- A QOF invests at least 90 percent of its assets in QOZ property. Substantially all of the tangible property owned directly or indirectly by the QOF must meet the following requirements:
- Acquired by purchase after Dec. 31, 2017
- Acquired from an unrelated party
- The original use commenced with the QOF or the QOF substantially improved the property.
- Substantial improvement is defined as additions to the basis during any 30-month period after the acquisition exceeds the adjusted basis at the beginning of the 30-month period.
- Substantially all of the use of such property is in a QOZ during substantially all of the QOF’s holding period
An example may help illustrate the benefits of QOFs. Let’s say a real estate investor is interested in investing $100,000 in 2018 into a partnership that will undertake a rental real estate development in a QOZ. Assume that the investor owns stock with basis of $50,000 and a fair market value of $150,000. If the investor sells the stock and realizes a gain of $100,000, such gain can be deferred until Dec. 31, 2026, to the extent the gain is invested in a QOF within 180 days. Since the investor will have held its interest in the QOF for over seven years at the time the deferred gain is recognized, 15 percent of the deferred gain is excluded from taxable income. If the investor sells its interest in the QOF for $200,000 after holding it for more than 10 years, then 100 percent of any gain realized in connection with such a sale will be excluded from taxable income. Such excluded gain could be more than the $100,000 appreciation in the QOF investment if the investor was allocated losses during its holding period.
In this example, the new opportunity zone legislation enabled the investor to realize $250,000 in net proceeds ($50,000 stock sale + $200,000 QOF sale) on an investment with an original basis of $50,000, while only paying tax on $85,000 of the $200,000 gain. To top it all off, the only gain that was recognized was deferred more than eight years and the investor may have been able to claim ordinary losses from the investment during its holding period thus further reducing the tax consequences of the investment.
While the concept of the opportunity zone program is fairly straightforward, there are many potential foot-faults that could disqualify a taxpayer from receiving some or all of its benefits. Consequently, real estate developers and investors need to be very careful when structuring transactions to take advantage of the benefits of this new program, particularly if such transactions will precede the issuance of IRS guidance. Until guidance is released, real estate developers and investors should consider conservatively interpreting the statute where ambiguities may exist. Special attention should also be given to the following:
- Ensuring that the investment into the QOF is properly structured to enable the taxpayer making such investment to receive the benefits of the program.
- Maximizing the benefit of the exclusion that is available upon the sale of an investment in a QOF with an over 10-year holding period.
Many questions remain
The TCJA laid the groundwork for this new incentive and set out the basic parameters. Much of the responsibility for turning the theory of the new law into reality will fall to Treasury and the IRS. So far, the process of designating QOZs is substantially complete and the IRS issued taxpayer-favorable guidance enabling QOFs to self-certify. However, many details regarding the administration of the program remain unclear and many questions remain about how the law will operate in practice. Guidance should help to answer questions such as:
- What types of gain qualify for deferral other than long-term capital gain? Short-term capital gain? Section 1231 gain? Ordinary gain?
- Are gains from the sale of a QOF after 2028 eligible for exclusion even though QOZ designations expire on Dec. 31, 2028?
- How will debt of a QOF impact the calculation of a partner’s gain exclusion?
- How will the substantial improvement test apply to land?
- How much flexibility will QOFs have to reinvest proceeds from the sale of QOZ property?
In addition to questions at the federal level, treatment of QOFs could vary state to state. So far, only Hawaii has taken steps to “decouple” from the federal tax treatment of opportunity zones, but more states could follow.
The key for real estate developers and investors at this time is to familiarize themselves with the opportunity zone program so that they can take advantage of its benefits when planning new projects. If you’re considering undertaking or investing in a development project in a QOZ, please give us a call so that we can help you navigate through the potential landmines to properly structure the transaction.