While much of the focus of The Tax Cuts and Jobs Act of 2017 has been on business entity structures and new rules for tax deductions, the Act included new tax breaks for those investing in some of the nation’s poorest neighborhoods. A new “opportunity zone” tax incentive enables private investors to reinvest their profits in areas of the U.S. that typically fly under the radar. On October 19, 2018, the IRS unveiled proposed regulations to provide investors with guidelines about how they can qualify for the tax breaks, including which type of entities can invest in Opportunity Zone funds and which projects qualify.
While many of the details need to be ironed out by further guidance, here is what you should know about opportunity zones.
Opportunity zones are census tracts in economically distressed communities where new investments may be eligible for preferential tax treatment. The premise behind opportunity zones is to attract private investment in low-income, suburban and rural areas of the country. Once capital is invested in these zones, the entire community would benefit. Treasury Secretary Steven Mnuchin predicts the zones will attract more than $100 billion in private capital.
The IRS recently certified opportunity zones for investment in all 50 states to spur economic activity through the creation of qualified opportunity funds (QOFs). QOFs are partnerships or corporations formed specifically to invest in opportunity zones. Governors can choose up to one-quarter of their states’ low-income census tracts for opportunity zones. When the last tracts are approved, there will be a total of 8,700 census tracts designated as opportunity zones.
Rules of the Zone: How Does it Work?
While investors will not receive up-front tax credits, they can reinvest capital gains from other investments into opportunity zones. The benefit is very similar to that of the popular section 1031 exchange, but it has the makings of a much more lucrative tax benefit than a traditional 1031 transaction.
Capital gains on investments in QOFs held for five years are reduced by 10 percent; if held seven years, they are reduced 15 percent. If the investment in the QOF is held for at least ten years, the investor is eligible for an increase in basis equal to the fair market value of the investment on the date it is sold or exchanged. Again, there would be no capital gains on qualified investments held for ten years or longer. See below for an example.
Qualified Opportunity Fund:
You have a property (or stock) worth $1mm and a basis of $600K. You can sell the property and keep $600K in cash (tax free), and invest the $400K of gain in a QOF without it being taxed. If you wait 10 years to sell the QOF, any appreciation on the $400K you invested is completely tax free. Assuming 10% rate-of-return, your $400K investment grew to just over $1mm in the 10-year period. The entire appreciation of $600K (1mm – 400K) is tax free gain! The 400K in gain you originally rolled over into the QOF will be taxed at the same rate it would have been had it not been deferred by the QOF.
NOTE: If you invested the entire $1mm sales price in the QOF, only the appreciation attributable to the capital gain portion ($400K) is eligible for the QOF deferred gain treatment.
Traditional 1031 exchange:
The same set of circumstances applies. You have a property worth $1mm and a basis of $600K. You can utilize a 1031 exchange and defer the $400K gain by selling that asset and using the proceeds to buy another qualified property. Your entire gain of $400K is deferred until you sell your new property as long as the total amount of $1mm sales price is put into the new asset. Once the new property is sold, you will pay tax on the $400K in addition to any other capital gains that have accrued due to appreciation.
In a 1031 exchange, all of your cash is tied up in the deal. Using a QOF, you can pull cash out equal to your basis, reinvest the capital gains while still deferring them, and get an additional huge benefit of completely eliminating 10 years’ worth of accrued capital gains.
The creation of funds will be up to the private sector, and there is no cap on the number of dollars that can flow into opportunity zones. However, investments cannot originate from casinos, country clubs, and other “sin list” sources. Financial companies that lend and invest as their core business are also forbidden to invest in opportunity zones. However, other investors can sell a variety of assets, such as a business, stocks and even art to reinvest in opportunity zone funds. You must invest in a QOF by December 31, 2019 in order to receive the benefits.
Treasury Department to Clarify Grey Areas
States are already outlining recruitment strategies to attract investors as investors begin to establish funds, raise capital and target potential investment opportunities. Still, there are a number of technical matters that will need to be resolved before one pursues a QOF structure.
Questions for prospective QOF investors include:
- How soon after a QOF receives an investment of cash must it be invested in qualifying opportunity zone property?
- If an investor meets the 10-year holding requirement, must they request a refund for tax paid after 2026?
- Will an investor meeting the 10-year holding requirement must request a refund for tax paid after 2026?
- It appears that gain from the sale of qualified opportunity zone property cannot be further deferred under the opportunity zone program because QOFs must be organized for investing in qualified opportunity zone property, not interests in other QOFs. If a QOF sells assets, how long is a “reasonable period of time” within which cash proceeds must be reinvested in qualified opportunity zone property?
The Treasury Department has issued a list of frequently asked questions regarding opportunity zones. The Treasury Department plans to issue another set of regulations later this year to address issues related to the ongoing operations of a fund. Investors should consult with a qualified tax advisor and continue to watch for additional guidance on QOFs.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.