Opportunity Zones as an opportunity for Tax Deferral
Updated: Jan 10
What is an Opportunity Zone? In the Tax Cuts and Jobs Act which was enacted in December of 2017, Congress enacted provisions designed to encourage investment and economic growth in low-income communities.
Sec. 1400Z-1 allows for almost 9,000 low-income communities to be designated as "qualified opportunity zones" (QOZs). A Map of all QOZs can be found here (https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml)
Sec. 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a business located within one of these QOZs:
(1) the temporary deferral of capital gains, to the extent the gains are reinvested into a "qualified opportunity fund" (QOF);
(2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and
(3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.
Sec. 1400Z-2 entails a specific process, complete with critical definitions, deadlines, and quantitative tests that must be satisfied before the promised tax benefits become a reality. The life cycle of an opportunity zone investment can be represented at a high level as follows:
A taxpayer realizes gain taxed as capital gain --> The taxpayer reinvests the gain within 180 days into a QOF and defers the gain for the year of sale --> The QOF conducts business, either directly by holding qualified opportunity zone business property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest --> After holding the interest in the QOF for five years, the taxpayer excludes 10% of the original deferred gain --> After an additional two years, another 5% of the original deferred gain is excluded --> Any remaining deferred gain is recognized on Dec. 31, 2026 unless an "inclusion event" occurs prior to that date --> After holding the interest in the QOF for a total of ten years, the taxpayer may sell the investment in the QOF -- or, in limited circumstances -- the QOF may sell its assets -- at any time before 2048 and the taxpayer exclude the gain resulting from the sale. (https://www.forbes.com/sites/anthonynitti/2019/04/22/irs-releases-latest-round-of-opportunity-zone-regulations-where-do-we-stand-now/#4b651db32772)
Gains reinvested into a QOZ can be deferred until Dec. 31, 2026 (with a small portion of the deferred gain potentially escaping tax altogether if the investment is made before Dec.31, 2019 or Dec. 31, 2021). If the investment in the QOF is held for more than 10 years, then the basis of the investment is treated as being equal to its fair market value on the date the investment is sold, and all of the future gain on the investment is effectively exempt from tax.
Qualified Opportunity Funds (QOF)
A taxpayer may defer eligible gain only if, within 180 days of the sale or exchange, some or all of the gain is reinvested into a QOF. A QOF is a special-purpose entity that effectively acts as a conduit ensuring that invested capital is ultimately employed in a business located within a QOZ. A QOF may be a corporation or partnership and may be newly formed or a preexisting entity. A QOF does not need to be located within a QOZ. A QOF must self-certify that it is a QOF by filing Form 8996, Qualified Opportunity Fund, with its tax return for each year the entity intends to operate as a QOF. In the first tax year the entity intends to operate as a QOF, the entity has the option of specifying the first month it wants to be a QOF. If no month is specified, then the first month of the entity's initial tax year as a QOF is treated as the first month that the entity is a QOF. Designation of the initial year and month as a QOF is critical, because any eligible gain invested by a taxpayer into an entity before the entity's first month as a QOF is not eligible for deferral.
A QOF must hold at least 90% of its assets in QOZP (the "90% test"), determined by the average of the percentage of QOZP held in the fund, as measured on:
The last day of the first six-month period of the tax year of the QOF, and
The last day of the tax year of the fund.
By requiring that a QOF hold 90% of its assets in the form of QOZP, Sec. 1400Z-2 ensures that the QOF is investing in a business located within a QOZ. There are three types of QOZ property:
QOZ stock, or
QOZ partnership interests.
The first option permits a QOF to operate a business directly. The latter two options permit a QOF to operate a business indirectly through a subsidiary. Four tax benefits by investing in Opportunity Zones:
Tax benefit No. 1: Deferral of eligible gain
Tax benefit No. 2: Exclusion of 10% of the deferred gain
Tax benefit No. 3: Exclusion of additional 5% of the deferred gain
Tax benefit No. 4: Exclusion from gain on the sale of a QOF interest held longer than 10 years
There are a lot of different kinds of people or entities that could use or benefit from QOZs. Managers of existing funds looking for additional sources of capital or looking to diversify their fund offerings, family offices or high net worth individuals with substantial unrealized capital gains, entrepreneurs looking for different ways to start or expand businesses in QOZs, existing businesses looking to expand their operations or geographic footprint either within or into QOZs, individuals in the real estate industry that could use the new, tax-efficient sources of capital for ground-up development or renovation projects.
If you have any questions or if we can be of assistance, please do not hesitate to contact us.