Opportunity Zones and Opportunity Funds: A Major Tax Cuts and Jobs Act Investment Initiative
The “Opportunity Zone” program, a product of the 2017 Tax Cuts and Jobs Act (the “TCJA”), was created to “spur investment in distressed communities throughout the country.” “Qualified Opportunity Zones” (“QOZs”) are designated low-income community population census tracts within the various states and U.S. possessions; the designation remains in effect from the date of designation to the close of the tenth calendar year beginning on or after the date of designation (i.e., December 31, 2028). States had until April 20, 2018 to submit nominations for zones to be designated as QOZs. QOZs have currently been approved in all 50 states and the District of Columbia, as well as five U.S. territories (including all of Puerto Rico).
Much attention is currently being directed to the creation of “qualified opportunity funds” (“QOFs”), the vehicle through which such investments are to be made. That is not surprising -- such investments provide investors with significant tax benefits, specifically: (1) temporary deferral of tax on gains; (2) elimination of up to 15% of the tax on the deferred gain: and (3) the potential exclusion from tax on gain generated from the appreciation of investments within the QOF.
Temporary Deferral of Tax on Gains
Gain from an “unrelated”-party sale or exchange of property which is used to invest in a QOF is deferred until the earlier of December 31, 2026 or the date on which the investment in the QOF is sold. The investment in a QOF must be made within 180 days of the sale or exchange of property in order to qualify for deferral (IRC Sec. 1400Z-2(a)(1)(A)).
It is unclear whether “gain” that is characterized as ordinary income is entitled to the tax benefits here described. While the heading to the operative Internal Revenue Code section (IRC Sec. 1400Z-2) and the TCJA Conference Report refer to “capital” gains, the statutory language makes reference simply to “gain” or “gains.” Clarification is needed to confirm whether ordinary gain/depreciation recapture income is entitled to deferral and partial non-recognition.
What are related parties for this purpose? The criteria for being related parties is more stringently applied here than in other federal income tax contexts, substituting a more-than-20% ownership test for the more typical more-than-50% threshold. So, for example, for this purpose, an individual and a corporation should be related where more than 20% in value of the corporation’s outstanding stock is owned directly or indirectly by the individual. Similarly, two partnerships in which the same persons own, directly or indirectly, more than 20% of the capital interests or the profits interests should be related.
If an investor makes an investment in a QOF in excess of the gain realized from recent sales or exchanges, such investment is treated as two separate investments, one investment that only includes amounts covered by the Opportunity Zone program and a separate investment consisting of other amounts.
The deferral of gain applies to any property held by the taxpayer, including, for example, sales of stock, tangible personal property and real property, at the election of the taxpayer. The gain deferred cannot exceed the aggregate amount invested by the taxpayer in a QOF during such 180-day period. For amounts of the gain that exceed the maximum deferral amount, the gain is recognized and included in gross income as under pre-TCJA law. Unlike IRC Sec. 1031 exchanges, which (i) require re-investment of the proceeds (and not just the gain, as with the QOF) for deferral treatment and (ii) are currently limited to real property as a result of the TCJA, this incentive provides a new opportunity for investors with low basis assets and serves as an alternative for investors whose assets no longer qualify for IRC. Sec. 1031 exchange treatment or who are unable to identify a like-kind asset. And, there is no limitation on the amount of gain that can be deferred (or excluded, as described below) under this program.
There would appear to be nothing currently in the law that limits the deferral incentive from being used in conjunction with the New Markets Tax Credit (“NMTC”)1 or Low-Income Housing Tax Credit (“LIHTC”),2 which could prove to be a boon to investors who are able to utilize each credit to maximize tax benefits. Treasury has not yet released guidance on QOFs; it is certainly possible that the interplay between the various credits and incentives may be limited to prevent abuse.
Elimination of up to 15% of the Tax on the Deferred Gain
Where deferred gain is used to invest in a QOF, the investor’s initial basis in the QOF is zero. Five years after investment in the QOF, the basis is increased to 10% of the deferred gain, thereby eliminating 10% of the taxable gain. After seven years, the basis is increased an additional 5%, resulting in a total of 15% elimination of tax on the deferred gain (IRC Sec. 1400Z-2(b)(2)(B)).
The remaining deferred gain (or the fair market value of the investment if lesser) must be recognized on the earlier of the date on which the investment is sold or exchanged, or December 31, 2026. (IRC Sec. 1400Z-2(b)(1)).
Exclusion from Tax on Gains from Appreciated Assets
If an investment in a QOF is held for at least ten years, the investor can elect to have the basis of the investment equal the fair market value of the investment as of the date of sale or exchange (“FMV basis election”) (IRC Sec. 1400Z-2(c)). In other words, no gain is realized on the appreciation of the investment. Losses associated with investments in QOFs should be recognized as under pre-TCJA law. Since all QOZ designations terminate after December 31, 2028, it is not clear whether an investor who has not held an investment in the QOF for at least ten years by December 31, 2028 can qualify for this permanent exclusion of post-acquisition gains. Guidance from the IRS is required.
The following is an illustration of the mechanics of the tax incentive:
An investor, Z, sells stock, realizing a $500,000 capital gain in July 2018. On August 1, 2018, Z invests $500,000 in a QOF. Z makes an election to apply IRC Sec. 1400Z-2 to the $500,000 gain. No capital gain is recognized on his 2018 tax return filed in 2019.
- If Z sells his interest in the QOF prior to August 1, 2023 (the five year anniversary of the investment in the QOF), the $500,000 of capital gain must be recognized at that time.
- If Z sells his interest on or after August 1, 2023 but before August 1, 2025, Z increases his basis by $50,000 (or 10%) and recognizes $450,000 of capital gain upon the sale.
- If Z sells his interest on or after August 1, 2025 (the seven year anniversary of the investment in the QOF) but before December 31, 2026, Z increases his basis by $75,000 (or 15%) and recognizes $425,000 of capital gain upon the sale.
- If Z has not sold his interest prior to December 31, 2026, then on December 31, 2026, Z recognizes $425,000 of capital gain.
- If Z sells his interest in the QOF after December 31, 2026 but prior to August 1, 2028, Z will recognize gain upon the sale to the extent it exceeds $500,000.
- If Z sells his interest in the QOF on or after August 1, 2028, Z can make an FMV basis election and will not recognize any gain on the sale or exchange.
In order to qualify as a QOF, an investment vehicle:
- must be “organized” as a corporation or partnership for the purpose of investing in QOZ property (other than another QOF), and
- 90% of its assets must be QOZ property determined by the average of the percentage of QOZ property held in the fund as measured (i) on the last day of the first six-month period of the taxable year of the fund and (ii) on the last day of the taxable year of the fund.
It is unclear whether cash will be considered for the 90% asset test. In the case of a QOF which has excess cash due to undeployed capital, a QOF may unwittingly fail the 90% asset test. In some cases, debt vehicles may be used by the funds to hold cash and/or other “bad assets” in order to ensure that the 90% asset test is met. Alternatively, QOFs may be established as single-investment vehicles where the QOF finds a property prior to identifying investors.
While there was initial ambiguity as to how certification as a QOF would be established, the IRS has issued guidance that eligibility will be through self-certification. In other words, a taxpayer will complete and attach a form (to be released in the summer of 2018) to its timely filed federal tax return (including extensions).
Whether a limited liability company will qualify as a QOF is not clear. However, a REIT should qualify as a QOF where it is organized as a limited partnership or a corporation.
QOZ property is defined as property which is: (1) QOZ stock, (2) a QOZ partnership interest or (3) QOZ business property (IRC Sec. 1400Z-2(d)(2)(A)).
QOZ stock is stock in a domestic corporation satisfying three requirements: (1) stock in a QOZ business must be acquired by the QOF after December 31, 2017 at its original issue (directly or through an underwriter) from the corporation solely in exchange for cash; (2) as of the time the stock was issued, the corporation was a QOZ business (or, in the case of a new corporation, the corporation was formed for the purpose of being a QOZ business, explained below); and (3) during substantially all of the QOF’s holding period, the corporation is qualified as a QOZ business (IRC Sec. 1400Z-2(d)(1)(B)). So as to avoid not being treated as QOZ stock in the hands of a QOF, the corporation cannot engage in certain specified redemption activities.
QOZ partnership interest
A QOZ partnership interest is defined as any capital or profits interest in a domestic partnership if: (1) the interest is acquired by the QOF after December 31, 2017 from the partnership solely in exchange for cash; (2) as of the time the interest was acquired, the partnership was a QOZ business (or, in the case of a new partnership, the partnership was formed for the purpose of being a QOZ business); and (3) during substantially all of the QOF’s holding period for such interest, the partnership qualified as a QOZ business (IRC Sec. 1400Z-2(d)(1)(C)).
It should be noted that the QOF cannot contribute an existing QOZ business into a corporation or a partnership in exchange for stock or a partnership interest as the interest must be acquired solely for cash. This may discourage sellers that want to participate in the appreciation of value of their QOZ business/property.
QOZ business property
QOZ business property is tangible property used in a trade or business of the QOF if: (1) the property was acquired by the QOF by purchase after December 31, 2017; (2) the “original use” of the property in the QOZ commences with the QOF or the QOF “substantially improves” the property; and (3) during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ (IRC Sec. 1400Z-2(d)(1)(D)). It is not entirely clear what is meant by original use for this purpose; clarification is required. Property is treated as substantially improved by the QOF only if, during any 30-month period beginning after the date of acquisition of the property, additions to basis with respect to the property by the QOF exceed the adjusted basis of the property at the beginning of that 30-month period. So, for example, a building purchased within a QOZ for $5 million would need to be improved by an amount in excess of $5 million within such 30-month period to be “substantially improved.”
Both the QOZ stock and QOZ partnership interest require that the acquired or newly created entity be a QOZ business. The term means a trade or business in which: (1) substantially all of the tangible property owned or leased by the taxpayer is QOZ business property (as described above); (2) at least 50% of the gross income is derived from the active conduct of the trade or business; (3) a substantial portion of any intangible property is used in the active conduct of the trade or business; (4) less than 5% of the average of the aggregate unadjusted bases of the property is attributable to “nonqualified financial property;” and (5) the trade or business is not a specifically excluded business within IRC Sec. 144(c)(6)(B) (i.e., golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facilities used for gambling, or any store where the principal business is the sale of alcoholic beverages for consumption off premises) (IRC Sec. 1400Z-2(d)(3)).3
Failure to Meet QOF 90% Asset Test Requirement
If a QOF fails to meet the 90% asset test, the QOF will be subject to a penalty for each month that it fails to meet the requirement. The amount of the penalty for each month will be equal to (1) the excess of (a) the amount equal to 90% of the QOF’s aggregate assets over (b) the aggregate amount of QOZ property held by the QOF, multiplied by (2) the underpayment rate under IRC Sec. 6621(a)(2) for each month it failed to meet the requirement. If the QOF is a partnership, the penalty imposed is taken into account proportionately as part of the distributive share of each partner of the partnership. There is no penalty imposed where the QOF’s failure to meet the 90% asset test requirement can be shown to be due to reasonable cause (IRC Sec. 1400Z-2(f)).
Unlike REITs, where failure to meet asset test results in disqualification as a REIT, it appears that QOF status would not be lost in the case of a failure to meet the 90% asset test. However, Treasury may provide further guidance to address this topic.
State Tax Considerations
Many states begin their calculation of state income tax with federal adjusted gross income or taxable income. Additions (or addbacks) and subtractions are then taken into account. Whether or not the tax deferral, exclusion and/or basis increases from the Opportunity Zone program are being adopted by states has yet to be addressed by many of the states. Where states do not conform with federal law as to this provision, investors may be required to recognize gain on the sale of their federally deferred investment in the year of sale and without any basis increase. On the other hand, if states require no modification, the deferral, exclusion and basis increase may give the taxpayer state tax benefits to complement their federal tax benefits.
With significant tax and economic benefits, the Opportunity Zone program should attract substantial interest among investors and fund sponsors, as well as within the low-income communities designated by this program. However, much depends on the implementing regulations and other guidance to be issued by Treasury and the IRS. Such regulations should begin to issue shortly. EisnerAmper will provide updates as information becomes available.
1 The NMTC (IRC Sec. 45D) is a federal tax credit provided in exchange for investing in Community Development Entities, which are financial intermediaries that make loans and investments to businesses operating in low-income communities. The total credit is equal to 39% of the investment and is claimed over seven years. The credit expired at the end of 2014 but was extended by Congress through 2019.
2 The LIHTC (IRC Sec. 42) provides for a federal tax credit for creating affordable housing investments in low-income communities. The credit is either approximately 4% (rehabilitation projects and new construction financed with tax-exempt bonds) or 9% (generally available for new construction) per year for ten years, incurred for the development of low-income units in a housing project. Developers typically sell the tax credits to investors.
3 Nonqualified financial property means debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property but does not include cash, cash equivalents, or debt instruments with a term of 18 months or less (IRC Sec. 1397C(e)).