Taxpayers have a unique opportunity in 2019, thanks to a new program created more than a year earlier.
The “Opportunity Zones” program offers tax incentives to investors who, under certain circumstances, invest capital gains into projects designed to bolster economically struggling communities. While the program’s newness means potential investors may have unanswered questions, if the program works as designed it should be a win-win scenario. Investors secure generous tax benefits, and struggling communities experience an infusion of investor interest and potential job creation.
Qualified Opportunity Zones
The Tax Cuts & Jobs Act, which passed in late 2017, created the Opportunity Zones program. Investors can shelter capital gains from tax if they make long-term investments in these zones, which are census tracts that the Treasury Department has designated as experiencing economic distress. The law dictates that qualified Opportunity Zones retain their status for 10 years once they receive the designation.
The Opportunity Zones program was designed to spur investment and job creation in these distressed communities. The tax regulation also was meant as an incentive to encourage wealthy investors, such as Silicon Valley entrepreneurs, to liquidate highly appreciated securities and re-invest these assets outside of their companies, by relieving potential worries about a large capital gains tax bill.
The federal government provided a list of potential Opportunity Zones once the law took effect and allowed states to narrow their selection of census tracts for the ultimate list. The first zones were announced in April 2018; as of this writing, the government has designated 8,761 qualified Opportunity Zones spread across all 50 states, as well as the District of Columbia and several U.S. territories. Investors can participate in the program nationwide, as there is no requirement that they invest in zones within their own state of residence.
The government designated these zones based on census data from nearly a decade ago, which creates another enticing program feature. Some of the disadvantaged areas have become very desirable in the intervening years. For example, here in South Florida, Broward County has 30 Opportunity Zones and Miami Dade County has 68. These areas may be especially attractive to investors.
Since the Opportunity Zones program is so new, some of its rules are not yet entirely clear. The Internal Revenue Service issued a set of proposed regulations in October, which answered at least a few outstanding questions. For example, the regulations add detail to the rules for the organizations that operate in Opportunity Zones, which must meet certain requirements in order for their investors to secure the tax benefits of the program. The regulations also clarify that nearly all capital gains qualify for deferral in this program, including gains experienced by partnerships and pass-through entities such as limited liability companies. The IRS originally planned to have a hearing regarding these proposed regulations on Jan. 10, 2019, but the hearing was delayed because of the partial government shutdown. As of this writing, a new date has not been announced.
Yet while some questions remain unanswered, the clock is ticking for investors hoping to make the most of the Opportunity Zones program. Taxpayers who want the greatest tax benefit must invest before the end of 2019, so investors do not have the luxury of waiting indefinitely for regulators to hammer out the rules. Given this deadline, the Treasury Department stated that taxpayers may rely on the proposed rules before they are final, as long as they meet certain requirements. This assurance will allow investors to proceed with some level of confidence, even as the program evolves.
How To Take Advantage Of The Opportunity Zones Program
In order to take advantage of the tax benefits this program offers, a taxpayer must start with some form of capital gain. For example, the investor may have recognized a gain from selling a business, or simply from selling stock. The proposed IRS regulations define an eligible gain as any treated as a capital gain for federal income tax purposes, which casts a fairly broad net. The program also applies to either short- or long-term capital gains; either type of gain retains its status when the taxpayer participates in this program. Since short-term gains are taxed at a higher rate than long-term gains, this means the program may be especially attractive to investors who have assets that appreciated rapidly and may want to diversify a now-overweighted position.
To receive the program’s tax benefits, a taxpayer then invests this gain in a “Qualified Opportunity Fund.” It is important to note that a taxpayer cannot receive these tax benefits by investing in such a fund with cash from other sources. If an individual chooses to invest in the fund with something other than a capital gain, the investment confers no tax benefit. An investor who invests with both a capital gain and other cash will have to track each portion of the investment separately.
In order to secure its status, a Qualified Opportunity Fund must be a partnership or a corporation for federal tax purposes. It must also be organized in the United States (or a U.S. territory) for the purpose of investing in property in a qualified Opportunity Zone. And the fund must hold at least 90 percent of its assets in Opportunity Zone property. The Wall Street Journal reported in November 2018 that more than 40 funds were seeking to raise a total of at least $8.9 billion, suggesting there is a strong expected appetite for this program in its initial stages.
Taxpayers who want to take advantage of the program must invest the amount of the recognized capital gain in a Qualified Opportunity Fund within 180 days of triggering the gain. The clock does not stop at the beginning of the calendar year, so gains from 2018 may be invested in early 2019 as long as they fall within the 180-day window. The fund will then use the invested assets to acquire property in an Opportunity Zone directly or invest through another entity that purchases such property. If a pass-through entity plans to defer the capital gain, it must be invested within 180 days of the date the capital gain was triggered. If investors in the pass-through entity are going to invest the capital gain instead, they have the option to start the 180 day window either on the date the capital gain was triggered or on Dec. 31 of the year it was triggered.
Taxpayers recognize the immediate benefit of not having to report the capital gain on their tax return in the year they triggered it, but this is not the only potential upside. At the start, the taxpayer’s basis in the Qualified Opportunity Fund is $0, in exchange for the capital gain tax deferral. After five years, the taxpayer’s basis increases to 10 percent of the gain that he or she initially elected to defer. After seven years, the basis gets another 5 percent bump, for a total basis of 15 percent of the initial capital gain.
As I mentioned earlier, investors who want the greatest possible benefit need to invest in a Qualified Opportunity Fund by Dec. 31, 2019. This is because investors are allowed to defer tax on the original gain until the earlier of Dec. 31, 2026 or the date the investor sells or exchanges the position in the Opportunity Fund. Since all investors must report deferred capital gains by the end of 2026, regardless of how long they have held the property, securing the full 15 percent basis adjustment will only be possible for those who act quickly. At the end of 2026, taxpayers must recognize either the difference between the fair market value of the investment and their basis in the Qualified Opportunity Fund or the difference between the original deferred gain and their basis in the Qualified Opportunity Fund, whichever is less.
Once the capital gain is reported and the tax is paid for 2026, the investment’s basis will increase by the amount of capital gain reported. If the taxpayer continues to hold the investment to the 10-year mark and then sells it, the basis becomes equal to the fair market value of the investment on the day of the sale. Therefore the entire capital gain above the 2026 basis is wiped out. Theoretically, investors can continue to reap the benefits of tax free gains until Dec. 31, 2047, when the program ends.
Essentially, the program can give participating taxpayers three distinct benefits. They can defer tax on their initial capital gain until 2026. They can permanently exclude some portion, either 10 or 15 percent depending on the length of their investment, of the deferred gain. And they can permanently exclude all post-2026 appreciation in the investment if they hold their position for at least 10 years.
Like many tax programs, certain standards apply and testing will take place to ensure that investors are meeting all the requirements in order to receive their tax incentives. The program includes a test at six months and on Dec. 31 to make sure that all assets in a Qualified Opportunity Fund meet the “90/10” rule. This rule states that at least 90 percent of a fund’s assets must be qualified Opportunity Zone property: stock, partnership interests or business property. The precise rules about how the assets are measured, as well as what qualifies as Opportunity Zone business property, are beyond the scope of this article, but investors should be aware that if a fund fails this test, the government will impose financial penalties, which the fund will pass through to investors.
The basic idea of the program as I have explained it in this article is relatively straightforward. However, the details are complex, and they continue to evolve. Under the circumstances, taxpayers will be wise to involve a tax professional if they wish to participate. At a minimum, taxpayers should take care to document the logic behind their positions, and all other aspects of the transaction, thoroughly.
The Opportunity Zones program offers a new and exciting prospect for investors, with a generous tax incentive to encourage them to participate sooner rather than later. While many questions remain, it is clear regulators are doing all they can to give potential participants the green light even before regulations are fully final. With a bit of caution and common sense, taxpayers should make the most of the opportunity that Congress has created.