Over the years, cities, states and the federal government have created incentive programs that were designed to stimulate investment in disadvantaged, or economically challenged areas. Some incentive programs were structured as tax credits, some were low interest rate loans, while others were direct cash incentives or grants. Regardless of the structure, the ultimate goal was to help stimulate direct investment to create jobs, stimulate the economy and enhance the overall quality of life for an area. One of the most recent and successful programs designed to accomplish this stimulus goal in the Opportunity Zone.
The Opportunity Zone legislation was championed by U.S. Senator Tim Scott (R-SC), and strongly supported by President Trump. And, according to Senator Scott, there is no time like the present to accelerate and grow these Opportunity Zones. “As we work to recover from the economic effects of COVID-19, we cannot allow the patterns that emerged following the 2008 financial crisis to occur again,” Scott said. “The Opportunity Zones initiative has proven to be a powerful tool, and with these necessary adjustments, it will be a leader in helping our most vulnerable communities get back on their feet. Every American deserves the opportunity to succeed, a reality made even more imperative following COVID-19.”
The Creation of the Opportunity Zones
On December 22, 2017, Congress enacted H.R. 1, also known as the “Tax Cuts and Jobs Act” (the “TCJA”). Among many other provisions, the TCJA established a new tax regime for investments in vehicles established for the purpose of acquiring “qualified opportunity zone property.” These vehicles are referred to as “qualified opportunity funds” or “QOFs.” The tax regime is referred to as the “QOF Program.”
In order to qualify as a QOF, an investment fund will need to hold at least 90% of its assets in qualified opportunity zone property in each of its taxable years, determined by calculating the average of the percentage of qualified opportunity zone property held by such investment fund (i) on the last day of the first six-month period of the taxable year of such investment fund, and (ii) on the last day of each taxable year of such investment fund. Qualified opportunity zone property generally includes direct and certain indirect interests in businesses or property located in a population census tract that is (i) a low-income community (or contiguous with a low- income community) located in a state or possession of the United States and (ii) designated as a qualified opportunity zone by the applicable state or possession and approved by the U.S. government.
In addition to the potential tax benefits to investors described below, investing in qualified opportunity zones can benefit these underserved areas, as substantial real estate investment in qualified opportunity zones can assist in creating the infrastructure and economic growth necessary for attracting new business and investments to these areas, thereby, creating a cycle of economic growth.
Qualified Opportunity Zones
Under the provisions of Subchapter Z of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), as enacted by the TCJA, individual U.S. states and possessions have nominated certain census tracts to be designated as opportunity zones (“Opportunity Zones”). Such nominated census tracts have been certified by the Secretary of the Treasury. An Opportunity Zone generally must be a population census tract within a U.S. state or possession that qualifies as a “low income community” as defined under Section 45D(e) of the Code (or, in certain cases, is contiguous to a low-income community). A low-income community is a population census tract with either a poverty rate of no less than 20 percent, or a median family income that does not exceed 80 percent of either the statewide or metropolitan area income, depending on the tract’s location. The number of Opportunity Zones designated in each U.S. state or possession cannot exceed 25 percent of the number of population census tracts in such U.S. state or possession that qualify as low income communities, provided that if a U.S. state or possession has fewer than 100 low income communities, it may designate up to 25 of such low income communities as Opportunity Zones.
As of June 2018, all 50 states, the District of Columbia, and five U.S. possessions had areas designated as qualified opportunity zones; a total population of nearly 35 million Americans live in these approximately 8,700 designated communities.
Qualified Opportunity Fund Program Need
Since the 2008 financial crisis, and excluding the recent effects of COVID-19, the U.S. economy had enjoyed a strong recovery, but the recovery has not been distributed evenly across the United States. Based on data from the 2011-2015 American Community Survey, qualified opportunity zone-eligible census tracts had an average poverty rate of over 32%; the poverty rate for the average U.S. census tract is 17%. During that same timeframe, qualified opportunity zone-eligible census tracts have lost an average of 6% of jobs while the United States on average experienced job growth. The QOF Program was created in order to spur economic investment and development for these historically underserved areas in order to rebalance the uneven post-crisis economic recovery.
Potential Tax Benefits
The QOF Program is intended to provide investors in QOFs four types of potential tax benefits:
- Temporary Deferral:
There are two kinds of deferral that occur:
- If a taxpayer realizes eligible capital gain from the sale or exchange of any property to or with an unrelated person, the taxpayer, generally, has 180 days from the sale or exchange to elect to defer all or part of the eligible capital gain from the sale or exchange by investing the gain in a QOF. Eligible capital gain does not include (i) certain gains from “section 1256 contracts,” i.e., any regulated futures contracts, foreign currency contracts, non-equity options, dealer equity options, dealer security futures contracts, and (ii) any capital gain from a position that is or has been part of an “offsetting- positions transaction.” The 180-day period for investing eligible capital gains from section 1231 property in a QOF begins on the last day of the taxable year (i.e., after the amount of long-term capital gains from such property can be determined). The amount of the eligible capital gain that has been invested in a QOF by the taxpayer is referred to as the “Deferred Gain Amount.” The taxpayer’s equity interest in a QOF that is attributable to the Deferred Gain Amount and invested in the QOF is referred to as the “QOF investment” and such Capital Gain may be deferred. The taxpayer is required to include the Deferred Gain Amount (subject to certain adjustments described below) in its taxable income on the earlier of (i) the date the taxpayer sells or exchanges QOF investment, with some exceptions (explained below), and (ii) December 31, 2026 (the applicable date, the “Inclusion Date”).
- Because of the deferral of the Deferred Gain Amount, the taxpayer also gets to defer payment of the 3.8% net investment income tax that applies to certain high earners until the Inclusion Date – as stated above.
- Step-up in Basis:
The initial tax basis of the QOF investment will be zero.
If the taxpayer holds the QOF investment for at least five years and the Inclusion Date has not yet occurred by such 5th anniversary, the tax basis of the QOF investment will be increased by an amount that equals 10% of the Deferred Gain Amount.
If the taxpayer holds the QOF investment for an additional two years (or seven years in total) and the Inclusion Date has not yet occurred by such 7th anniversary, the tax basis of the QOF investment will be increased by an additional amount that equals 5% of the Deferred Gain Amount (or 15% in total).
Upon the Inclusion Date, the taxpayer will be required to include as capital gain on its tax return an amount equal to the excess of (i) the lesser of (x) the Deferred Gain Amount or (y) the fair market value of the QOF investment, in each case as of the Inclusion Date, over (ii) the taxpayer’s basis in the QOF investment as of the Inclusion Date; immediately upon this tax event, the tax basis of the taxpayer’s QOF investment will be increased by the amount of gain so included. The deferred gain that is included by the taxpayer on the Inclusion Date will have the same tax character as such gain would have had if it had not been invested in a QOF.
- Permanent Exclusion:
If the taxpayer holds the QOF investment for at least 10 years, the taxpayer can make an election whereby the taxpayer’s basis in the QOF investment will be made equal to the fair market value of the QOF investment on the day the QOF investment is sold or exchanged. Generally speaking, this means that no U.S. federal income tax will be owed with respect to appreciation in the value of a QOF investment (i.e., a qualifying equity interest in the QOF) that is held for at least 10 years.
Placement or other similar fees paid by the investor are not expected to be treated as Deferred Gain Amounts invested in the QOF for these purposes.
|Investment Length||Potential Benefits|
|Fewer than 5 years||Deferred taxation of eligible capital gains that are invested in the QOF (“Deferred Gain Amount”) and deferred liability for the 3.8% net investment income tax otherwise imposed on the Deferred Gain Amount, until the earlier of (i) the date that the QOF investment is sold or exchanged or (ii) December 31, 2026|
|5 years or more (if QOF investment is made no later than 12/31/21)||10% of the Deferred Gain Amount is eliminated|
|7 years or more (if QOF investment is made no later than 12/31/19)||15% of the Deferred Gain Amount is eliminated|
|Greater than 10 years (if QOF investment is made no later than 12/31/26)||No U.S. federal income tax will be owed with respect to the post- investment appreciation in the value of the QOF investment|
The following illustrates the benefits that a taxpayer could receive by investing in a QOF if the taxpayer were to (i) sell stock in 2020 for $150,000 in cash, which was originally purchased for $50,000; (ii) contribute $100,000 in cash to a QOF in exchange for an interest in the QOF in 2020 and within 180 days of such sale; and (iii) sell such interest in the QOF for $200,000 in 2030 (after holding the interest for more than 10 years). This example addresses only U.S. federal income tax consequences and does not address state, local or other tax consequences.
|Year 2020||Year 2025||Year 2027|
|Investor defers recognizing
$100,000 in eligible capital gains and defers liability for 3.8% net investment income tax on such gain.
Investor’s basis in the QOF increases from $0 to $10,000.
Investor’s basis in the QOF increases from $10,000 to
|Investor has a $0 basis in its interest in the QOF.|
|Year 2027||Year 2030|
|Investor recognizes $85,000 in capital gains in 2027 ($100,000 of deferred gain minus $15,000 of basis increase as described above) on which the taxpayer would owe tax at the rates in effect for 2027.||
Investor owes no additional U.S. federal income tax on the $100,000 economic gain from the sale of the QOF interest, realized in 2030. Note that this tax benefit is available if the QOF interest is sold on or prior to December 31, 2048, and the QOF has maintained its QOF status throughout the investor’s holding period.
|Investor’s basis in the QOF increases to
$100,000 as a result of 2027 gain recognition.
THIS SUMMARY IS NECESSARILY GENERAL AND IS QUALIFIED IN ITS ENTIRETY BY THE STATEMENT THAT THIS DOCUMENT SHOULD NOT BE CONSTRUED AS TAX OR OTHER INVESTMENT ADVICE. ANY SUCH ADVICE SHOULD BE RECEIVED BY A LAWYER OR TAX ADVISOR.