In December of 2017, the Tax Cuts and Jobs Act outlined a new program called “Opportunity Zones” (OZs) that offered tax breaks for investing in underdeveloped/distressed communities via Qualified Opportunity Funds (QOFs). In October 2018, substantially more detail on the OZs was provided, and in April 2019, the IRS and Treasury Department issued a 169-page document that detailed regulations governing OZs.
According to the IRS, a QOF is set up either as a partnership or corporation (LLCs qualify also) for investing in an eligible property located in one of the OZs. Only money from capital gains can be invested in a QOF and the recently issued regulation clarify that deferral is permitted on whatever percentage of a gain the recipient of the gain invests in a QOF.
The deferral of the gain continues until the investment is sold/exchanged, or until December 31, 2026, whichever comes first. And the deadline for investing capital gains in an OZ/QOF is also December 31, 2026. Tax considerations depend on how long an investment remains in a QOF.
- If an investment remains in a QOF for 5 years, taxes are deferred and there is a 10 percent reduction in the amount of the gain that is taxable.
- If it remains for 7 years, taxes are deferred and there is a 15 percent reduction.
- If it remains for 10+ years, taxes are deferred and the gain may qualify for tax-free status.
For example, if an investor realizes a $1 million gain on a sale of stock, and that entire gain is invested in a QOF and kept there for 5 years, the taxable amount after that 5 years is now $900,000. If the whole gain stays in the QOF for 7 years, the taxable amount becomes $850,000. If the gain remains in the QOF for 10 years-plus, in addition to taxes being reduced, capital gains on appreciation are eliminated.
Following the above example, if the $1 million investment in the QOF appreciates to $5 million over a 10-year period, that means a gain of $4 million. According to the new regulations, if the investment in the fund is sold for $5 million, the investor pays tax only on the original $1 million and none on the $4 million gain.
However, the proposed regulations do not take a taxpayer-favorable view on carried interests. They state that only the portion of an investor’s equity that is attributable to capital is eligible for the exclusion from capital gains after the 10-year holding period is met. For example, if an investor contributes 10 percent of the capital but receives an interest in 20 percent of the profits above a certain IRR threshold, only the 10 percent interest would be eligible for the capital gains exclusion.
The new OZ/QOF regulations also address the original rule that at least 50 percent of a qualified business’s gross income had to come from within the OZ. This rule would have the effect of making QOF businesses mostly local, as in retail operations and rental properties. The new rules broaden the criteria from revenue generation exclusively to include service transactions and employee location. Meaning, QOFs are allowed three different methods of showing they conduct enough business within the zone: employee hours, where services are performed, and/or where management is located.
The new regulations also stipulate that when a business leases property in an OZ, that lease property meets the requirements as a qualified opportunity zone property. The new stipulation recognizes the fact that many businesses prefer leasing to owning, particularly start-ups with limited capital.
However, when a QOF owns actual property in an OZ, an investor/QOF must have purchased a tangible property after December 31, 2017. Meaning, a building in an OZ owned before 2018 is excluded from the OZ/QOF program. Also, land and vacant buildings now qualify as investments for a QOF.
Whether it is a tangible property or “a market rate lease,” according to the new regulations, properties “qualify as a ‘qualified opportunity zone business property’ if during substantially all of the holding period of the property, substantially all of the use of the property was in a qualified opportunity zone.” The new regulations also provide a numerical clarification defining exactly what “substantially all” means. According to the IRS:
- For use of the property, at least 70 percent of the property must be used in a qualified opportunity zone.
- For the holding period of the property, tangible property must be qualified opportunity zone business property for at least 90 percent of the QO Fund’s or qualified opportunity zone business’s holding period.
- The partnership or corporation must be a qualified opportunity zone business for at least 90 percent of the QO Fund’s holding period.
Some additional OZ/QOF clarifications and revisions contained in the new regulations include:
More ramp up time. Once a QOF receives its capital gains money, it can take 6 months to purchase assets that “qualify” for the various tax incentives.
More ramp down time. Investors now have a one-year grace period during which to sell QOF assets and reinvest the money made from the sale.
QOFs can hold more than a single asset. According to the new regulations, investors can create QOFs that hold multiple assets. This approach spreads liability and increases opportunity for increasing the worth of the QOF.
QOFs do not have to hold each asset within the fund for 10 years. This provides additional flexibility in that the fund can have a rolling investment strategy that reflects changing markets.
The new IRS/Treasury Department regulations address most but not all issues vis a vis OZs, including how do businesses meet the criteria for conducting business in an OZ? To answer that question, the IRS is currently soliciting suggestions on how economic activity might be measured and methods on how that information might be collected.