Opportunity Zones
The 2017 tax reform created a new tool for investors to reduce their tax liability called opportunity zones. Opportunity zones are land tracts that have been designated as economically disadvantaged. Governors, together with local officials, selected 8,700 census tracts to be certified as opportunity zones by the Treasury Department, such tracts being located across all 50 states, five territories, and Washington, D.C.[1] The purpose of certifying areas as opportunity zones was to encourage and support economic development and job creation in distressed communities[2]. Notably, Florida has 427 tracts designated as opportunity zones, while New York has 514 tracts designated as such.[3] Wherein hereafter this article refers to investments in “opportunity zones” it should be noted that we are discussing investments in “Qualified Opportunity Funds” (abbreviated as “QOF” hereinafter) that invest, either directly or indirectly, in businesses and real estate projects located in areas certified as “opportunity zones.”
Tax Advantages:
An investment in an opportunity zone allows an investor to defer income taxes on short-term or long-term capital gains realized on or after 2018 until December 31, 2026; or until such time as the investor completely divests from the opportunity zone investment, if done before December 31, 2026.
Unlike 1031 like-kind exchanges, opportunity zones do not require that the entire amount realized be reinvested in order to benefit from tax deferral. Rather, only the gain must be reinvested. Additionally, the gain may be fully or partially reinvested in opportunity zones, for full or partial deferral.
Investors are encouraged to maintain their investment in opportunity zones for an extended period of time, as the new law reduces the amount that is ultimately subject to tax, by up to 15%, based on the number of years the investment in the opportunity zone continues. Investors seeking to take advantage of the deferral and reduction of tax available have up to 180 days from the date of the sale of the capital asset to invest the gains in an opportunity zone.[4]
The mechanics are as follows:
Once an investor has realized capital gains and invests the gain in a QOF, income tax on the gain will be deferred as follows:
If the investor continues to hold his or her share of QOF for a period of five years, the investor’s original gain will be permanently reduced by ten percent.
If the investor holds his or share of the QOF for a period of seven years, the investor’s original gain will be permanently reduced by an additional five percent. This is accomplished through basis adjustments (hereafter referred to as “step-ups”) of the investor’s initial basis in the QOF; occurring at each interval described above. Each basis step-up proportionately reduces the amount of gain subject to taxes at the end of 2026.
If the investor holds the opportunity zone investment for more than ten years, the entire appreciation of the investor’s interest in the QOF will be wiped out at the time of sale and no additional taxes will be due. Note, however, that the originally deferred capital gain amount will be required to be included in income and subject to tax on December 31, 2026, regardless of any continued investment in a QOF (as mentioned above, the amount reportable as gain may be reduced, up to a maximum of 15%, by the step-ups if held for the requisite period of time).
For example, suppose that in 2018 an investor sells artwork and realizes $1,000 of long-term capital gain. Assume further that within 180 days from the sale, the investor invests that capital gain into a QOF. If the investor holds the shares of the QOF until 2023, she will receive $100 of basis step-up (i.e., 10% of $1,000), bringing her total cost basis in the QOF to $1,100. If the QOF investment is held until 2025, the investor would receive an additional $50 (i.e., 5% of $1,000) of basis step-up; bringing it to a total of $1,150 of capital gain eliminated. In 2026, the investor will recognize $850 of the originally deferred capital gain income (i.e., $1,000 - $150). If the investor sells her share of QOF in 2030 for a gain, no additional taxes will be due (as the QOF investment was held longer than 10 years).[5]
Qualification:
As mentioned above, in order to qualify, the investor must make the qualified opportunity zone investment through a QOF. A QOF can be structured as either a partnership or a corporation, established for the purpose of investing in a business or real estate project located in a qualified opportunity zone property.[6]
QOFs must meet an asset test, whereby 90% of its assets must consist of qualified opportunity zone property – namely, qualified opportunity zone business property or a qualified opportunity zone business. There are several statutory requirements that must be met, most notably though in order to qualify as a qualified opportunity zone business property the property must be (a) tangible; (b) used in the trade or business of the QOF; (3) acquired by purchase from an unrelated party or parties after December 31, 2017; and (4) the QOF must either commence the original use of the property or (5) make significant improvements to the property.
[1] https://www.forbes.com/sites/adamstrauss/2018/10/31/how-to-generate-tax-savings-by-making-impact-investments-in-opportunity-zones/#1764bb6f1e5c
[2] https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
[3] https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx
[4] Precise instructions on how to use form 8949 to elect deferral of the gain have yet to be released by the IRS.
[5] Stroock Special Bulletin, Qualified Opportunity Funds: Tax Strategies and Opportunities for Real Estate Investors and Other Investors, August 28, 2018.
[6] To become a Qualified Opportunity Fund, an eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return.