On October 3, 2018, the Senate Small Business Committee held a hearing on expanding the opportunities for small businesses through the tax code. In the meeting, many of the different provisions of the Tax Cuts and Jobs Act (TCJA) were discussed. Among those provisions being discussed Opportunity Zones under the TCJA were of particular focus. Then on October 22, 2018 the Internal Revenue Service (IRS) issued the much anticipated proposed regulations for the Opportunity Zone program.
Opportunity Zone Program
The Opportunity Zones program was established by Congress as an innovative approach to encourage long-term investments in economically distressed areas by giving investors preferential tax treatments for investing in qualified opportunity zones (QOZs). While the tax reform did not receive bipartisan support this aspect of the bill was based on a previously proposed bill that was generally bipartisan.
A “qualified opportunity zone” is defined by IRC Section 1400Z as a population census tract that is a low-income community that is designated as a qualified opportunity zone. (To see a full list of QOZs, please visit https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx). This program established tax incentives to spur business investment in these low-income communities with the hopes of producing economic growth.
In order to invest in qualified opportunity zones, investors are required to create a “qualified opportunity fund,” which is a privately managed investment vehicle that can be self-directed. A “qualified opportunity fund” is generally formed as a partnership, LLC or a Corporation, whose purpose of formation is to invest at least 90% of its assets directly into qualified opportunity zone property.
According to IRC Section 1400Z, a taxpayer may elect to exclude gain on the sale/exchange of any property to an unrelated third party in the year of sale/exchange if the taxpayer reinvested that gain in a qualified opportunity fund within 180 days of the sale/exchange. This election allows the taxpayer to defer the gain from sale/exchange until the year in which the investment is sold/exchanged or December 31, 2026, whichever is earlier.
In addition to the gain deferral, the provision also incentivizes long-term investing as follows:
|Investment Time Length||Tax Benefits|
|< 5 years||Deferred gains until the date that the Opportunity Fund investment is sold or exchanged.|
|5 to 7 years||The above benefits + 10% of the initially deferred gain will be permanently excluded.|
|7 to 10 years||The above benefits + additional 5% of the initially deferred gain will be permanently excluded.|
|> 10 years||The above benefits + investors pay no capital gains tax on the growth of the Opportunity Fund investment.|
These tax encouragements could be very enticing but investors who may be interested in QOFs should act promptly in order to ensure the full benefits. The max benefit (15%) that can be excluded from the deferred gain is only available until December 31, 2019, 7 years before the date the taxpayer would be required to recognize the gain without a sale or exchange and after 2021, while a taxpayer will still be allowed to defer the gain until 2026, they would not receive the added benefit since the holding period at the time of recognition would not have been 5 years or greater. All investors who hold the property for 10 years would still be eligible to exclude any future gains from the property.
Combining Tax Benefits of QOFs with Other Tax Credits
Other good news for investors is that the Opportunity Zone program does not prohibit qualified opportunity zone investments from being combined with other tax incentives. Therefore, by investing in QOFs, investors may also qualify for the following tax credits:
• Low-Income Housing Tax Credit (LIHTC)
• New Markets Tax Credit (NMTC)
• Historic Tax Credit (HTC)
• Renewable Energy Tax Credit (RETC)
Good News but Questions Still Remain
With the release of the recent regulations by the IRS, taxpayers have been provided some clarity and good news but there are questions that sill remain. One of the most surprising developments was that taxpayers are allowed to use the investments as collateral. This will provide the opportunity for investors to borrow against the investment without causing a recognition event. This is, however, different when it comes to refinancing a position and taking cash out of the Opportunity Zone fund. Under this strategy it would be considered a disposition and trigger the gain thus reducing the amount that would otherwise be eligible for the 10-year deferral.
Overall the feedback so far has been positive but stakeholders and practitioners have indicated that there are additional areas where guidance is needed. It is anticipated that the IRS will be issuing additional regulations in November or December to fill is some of the gaps that still exist. The message that has been communicated so far though is that this will hopefully not be another governmental process burdened with red tape, but a more streamlined, efficient process allowing for the investments to truly help the communities in need.
We will be working to closely monitor the developments in this area, and if you have any questions regarding the new Opportunity Zones program and how it might impact you and your business, or require any other assistance with your tax planning and compliance needs, please contact one of our knowledgeable team members.