In December, 2017, the Tax Cuts and Jobs Act of 2017, established Opportunity Zones by way of a provision of the Internal Revenue Code i.e Section 140OZ-2 (the "OZ Rules"). Pursuant to the OZ Rules, Treasury directed the individual states to designate certain census tracts as Opportunity Zones.
These areas are traditionally economically disadvantaged areas that have not experienced the growth that has benefited certain parts of our country since the end of the 2008 recession. The hope is that the designation of these Opportunity Zones will direct capital into those areas providing them with a necessary economic lift, which in turn has created some attractive options for investors.
As of June 14, 2018, all the states have designated their Opportunity Zones, and the Treasury on October 19, 2018 issued its first round of Regulations regarding Investing in Qualified Opportunity Funds, i.e. 26 CFR Part I, REG-115420-18. While there will be additional Guidance from the Treasury, we now have a framework within which to work, which is as follows:
Assume that a taxpayer sells his Amazon stock for $2 million and the stock had a basis of $1 million, resulting in a capital gain of $1 million. Since such a stock gain would inevitably have taken more than 12 months, we can assume that this is a long term capital gain, subject to the current 20% rate, plus the 3.8% add-on for the Affordable Care Act, for a total of 23.8% or $238,000 in taxes. To benefit from the OZ Rules, the above-mentioned $1 million capital gain would need to be invested into Opportunity Zone Property (i.e. real estate or a business - hereinafter referred to as "OZ Property") within 180 days of realizing the capital gain.
Note that there are 2 important distinctions for Opportunity Zone investments versus 1031 like-kind exchanges, i.e. (1) The capital gains can be invested in OZ "property" which does not have to be of a like-kind to the asset sold; and (2) The original basis of the asset does not have to be invested in the OZ Property (as it does in a 1031 like-kind exchange); and the taxpayer can invest up to the whole capital gain, but does not have to invest the entire gain.
If the capital gain is invested into a Qualified Opportunity Fund ("QOF") within 180 days, the QOF then has 180 days to invest into OZ Property. A QOF can be an entity, such as, but not limited to, a corporation, LLC, partnership, or limited partnership.
The QOF is able to self-certify on IRS Form 8996 when filing its first year tax return. Once the initial election is made, the taxpayer may elect the deferral on IRS Form 8949 in order to elect to increase the basis of the investment to the fair market value of the investment on the date that the investment is sold or exchanged.
The QOF needs to have 90% of its assets in OZ Property, calculated as either the value or the cost of assets. This 90% test is meant to be conducted each 6 months, and is also performed by the QOF via a certification on Form 8996.
If a QOF invests in a business within an Opportunity Zone, the test for determining whether the business qualifies as OZ Property is that it needs to have "substantially all" of its assets within an Opportunity Zone. The Regulations state that "substantially all" of its assets means 70% of its assets.
Furthermore, the Regulations require that the QOF "substantially improve" the OZ Property, which means that the QOF must invest at least 100% of the value of the OZ Property into the OZ Property.
A QOF can make either a direct investment (QOF owns the OZ Property) or an indirect investment (QOF owns stock or a partnership interest in an entity that owns the OZ Property) into OZ Property. For an indirect investment the OZ Property must actively generate income, i.e. >50% of income must be generated in the Opportunity Zone. Note that triple-net-leases are not considered active income generators.
Accordingly, assume the above $1 million capital gain is invested into a QOF by 12/31/2018, and that the QOF then invests in OZ Property valued at no more than $1 million, so that the "substantially all" test is met. The taxpayer will elect to defer the capital gain and pay no taxes on said gain in 2018. The taxpayer would have to pay 85% of the $238,000 in taxes i.e. $202,300 by 12/31/2026. The 85% calculation is allowed because the tax deferral date of 12/31/2026 is 8 years after the OZ investment was made, and per Section 140OZ-2, once said OZ Property is held for 7 years there is a 15% basis step up in the OZ Property. Thus, the taxpayer saves $35,700 in taxes, and defers said taxes for 8 years, benefiting from the time value of money thereof. Assume 10 year treasury rates are around 4%, that benefit would be $75,192 for a total benefit of $110,892. Calculated another way, the taxpayer would end up paying in 2026 only 57% of the total taxes that were due in 2018.
There is an additional benefit as well, in that if the taxpayer holds the OZ Property for 10 years, i.e. until 12/31/2028, all appreciation on the asset will be tax-free. Assume that the $1,000,000 invested in the QOF was valued at $1.4 million when sold in 12/31/2028, then the $400,000 in appreciation would be tax free.
There are several additional points to note:
(a) The taxes are only deferred until 12/31/2026, regardless of whether the OZ Property is sold. By way of example, in order to get the tax-free appreciation, the investment must be held until 12/31/2028, but taxes are due at 12/31/2026, so the taxpayer needs to ensure sufficient additional capital to pay the taxes at that time.
In the tax credit world, we have modeled transactions that generate tax credits, depreciation, cash flow, as well as the OZ benefits detailed herein. We like to use the tax benefits to satisfy the taxes at 12/31/2026, which is a considerable benefit to our deals; and
(b) The Regulations correct an apparent timing issue, in that (i) the Opportunity Zone designation per statute will expire on 12/31/2028; (ii) a taxpayer must hold the OZ Property for 10 years from the date the investment is made to achieve the 100% basis step-up; and (iii) the taxes are deferred only until 12/31/2026. The Regulations correct this imbalance as follows: Because the latest date for which a taxpayer may generate a capital gain is 12/31/2026, and a taxpayer would then have 180 days to invest that gain in a QOF, i.e. by June 30, 2027, and the QOF would then have 180 days to invest the funds into OX property, i.e. December 31, 2027 -- the 10 year hold would then run until 12/31/2037, and the Regulations allow another 10 years to dispose of the investment. Therefore, the taxpayer would have until 12/31/2047 to make the step-up basis election.