One of the least-discussed but most-consequential provisions of the Tax Cuts and Jobs Act of 2017 is the Qualified Opportunity Zone program. Championed by a bipartisan group of U.S. Senators, “O-Zones” present investors with an opportunity to roll capital gains into a tax-preferred investment, with both tax deferral and permanent benefit features.
How does the O-Zone Strategy work?
- A Taxpayer invests capital gains from the sale of an asset into a Qualified Opportunity Fund within 180 days of the asset sale. A Qualified Opportunity Fund is a fund which must hold at least 90 percent of its assets in Qualified Opportunity Zone Property. The Fund must file a form with the IRS after formation to designate itself as a Qualified Opportunity Fund, and must meet the 90 percent standard by the last day of the fund’s initial six months AND on the last day of each tax year. Investment in the Qualified Opportunity Fund can only be in the form of cash.
- The Qualified Opportunity Fund must invest in Qualified Opportunity Zone Property. What is Qualified Opportunity Zone property?
- Property Located in an Opportunity Zone. Opportunity Zones are low-income communities nominated by individual states and approved by the Treasury Department as Opportunity Zones. A map of Opportunity Zones prepared by the CDFI Fund can be found here.
- Qualified Opportunity Zone Property comes in three forms:
- Qualified Opportunity Zone Stock – Stock in a corporation that must be a Qualified Opportunity Zone Business. Qualified Opportunity Zone Businesses are businesses ”in which substantially all of the tangible property owned or leased by the taxpayer is Qualified Opportunity Zone Business Property.” The business must adhere to the requirements under IRC 1397C(b)(2),(4),(8). Certain businesses such as massage parlors, gambling enterprises, golf courses, country clubs, tanning salons, or liquor stores are excluded.
- Qualified Opportunity Zone Partnership Interest – basically the same framework as Stock, above, but within a Partnership framework.
- Qualified Opportunity Zone Business Property – Tangible property acquired after 12/31/2017 and used in a Qualified Opportunity Zone trade or business. The use of property in the Opportunity Zone must originate with the Fund, OR, the fund "substantially improves" property. The Internal Revenue Code defines “substantial improvement” as follows – during any 30-month period beginning after acquisition date, additions to basis exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QO Fund, so long as "during substantially all of the QO Fund's holding period of the property, substantially all of the use of such property was in a Qualified Opportunity Zone."
- The capital gain from the original asset sale is deferred until the sale of the Opportunity Zone Fund interest, subject to the following provisions:
- If the Investor holds the Opportunity Zone Fund interest for five years, the Investor receives a basis increase equal to 10 percent of the deferred gain, so long as the deferred gain was invested by December 31, 2021.
- If the Investor holds the interest for seven years, the Investor receives an additional basis increase of 5 percent in addition to the 5-year/10-percent increase above, so long as the deferred gain was invested by December 31, 2019.
- If the Investor holds the interest for 10 years beyond December 31, 2026, the Investor receives a step-up in basis in the Opportunity Fund equal to fair market value.
- If the Opportunity Zone Fund interest is held as of December 31, 2026, the Investor must pay the tax due on the deferred gain, less the basis increase from the 5 and/or 7-year hold.
- An Investor cannot invest deferred capital gains after December 31, 2026.
Jane Smith sells her interest in a Software Company on December 31, 2018, realizing a $1,000,000 gain. Jane then invests the $1,000,000 in ABC Property Fund on March 1, 2019. ABC Property Fund has been formed to develop a hotel in an Opportunity Zone located in Newark, NJ (assume ABC meets the formation requirements for a Qualified Opportunity Fund and does not run afoul of the 90 percent assets test). If Jane were to sell her interest before March 1, 2024, she would recognize capital gains on the deferred gain ($1,000,000) plus whatever gain is realized on the sale of the ABC interest. If, however, Jane held her ABC interest beyond March 1, 2024, she would benefit as follows:
|Transaction Date||Deferred Gain||Basis Step-Up||ABC Interest Sale Price / FMV||Capital Gains Recognized at Sale||Caveat|
|3/1/2029||$1,000,000||$1,000,000||$2,000,000||$850,000||$850,000 gain recognized on 12/31/2026|
What Investors Need to Know
- Watch for additional IRS guidance in Q4 of 2018 – There are still many areas for which Treasury/IRS must provide guidance (including the necessary forms to designate a Qualified Opportunity Fund). The expected guidance is currently under review by the Office of Management and Budget.
- Identify potential investments which may be for sale in Opportunity Zones – When evaluating potential investments, determine if the underlying entities or assets are located in an Opportunity Zone.
- Manage the calendar:
- First key date – an Investor has 180 Days from sale of asset to invest the gains (not the total proceeds) into a Qualified Opportunity Fund
- Second key date – the Opportunity Fund must have 90 percent of its assets invested in Qualified Opportunity Zone Property within six months of its formation
- Third key date – In order to qualify for the 15 percent step-up in basis by year seven (includes the 10 percent step up at year five), the investment must be placed by December 31, 2019.
Outstanding Issues Awaiting IRS Guidance
As mentioned above, Treasury/IRS submitted proposed rules and guidance to the Office of Management and Budget for review last quarter. As of October 2018, there are several unresolved issues which the guidance will hopefully address:
- Outlaying Funding – If a Qualified Opportunity Fund must hold a minimum of 90 percent of the fund’s assets in Qualified Opportunity Zone Property within six months of the Fund’s first tax year, what happens if a building the Fund invests in is still under construction at the 6-month mark?
- Re-Investments by Qualified Opportunity Funds – If a Qualified Opportunity Fund exits an investment in, say, 5 years, then invests those proceeds in another Qualified Opportunity Property investment that it holds for a further 5 years, do these investments fall under the same 10 year period?
- Partnership & LLC Implications – Can a Qualified Opportunity Fund be structured as an LLC? How do Qualified Opportunity Fund rules intersect with taxation of partnerships?
- Intersection with other Tax Credits – will the Opportunity Zone strategy impact incentives such as New Markets Tax Credits, Historical Building Credits, or Low Income Housing Credits?
- Leverage – Will debt financing impact the capital gain exclusion?
How A&M can help:
While Opportunity Zone investments present a tremendous opportunity for investors to realize significant tax savings, Opportunity Zones represent a completely new area of Federal Income Tax. Several aspects of the Opportunity Zone strategy represent “single points of failure” which could negate the benefit for ill-advised investors. A&M Taxand professionals can assist Investors, investment managers, and business owners throughout the entire life cycle of a Qualified Opportunity Zone opportunity.
Initial Formation & Structuring of Qualified Opportunity Fund entities – Performing initial compliance to ensure that a new entity and its investors meet the necessary requirements to execute the O-Zone strategy.
Federal and State Tax Compliance for Qualified Opportunity Funds – Federal & State income tax return preparation for the Opportunity Fund and its portfolio companies (if applicable); ensuring that the Opportunity Fund’s holdings meet the Qualified Opportunity Zone Property definition.
Due Diligence on Qualified Opportunity Fund transactions – Ensure that exits from Opportunity Fund investments are structured as tax-efficiently as possible and that all requirements are met to ensure full realization of Opportunity Fund benefits. Also, advise clients on optimal timing of exits to realize maximum benefits under the Opportunity Zone investment program.