The 2017 Tax Cuts and Jobs Act introduced a program known as the Qualified Opportunity Zone Incentive Program under Code Section 1400Z-2. The program was enacted to promote economic growth and investment in specifically designated low-income housing areas — or opportunity zones. It is the first of its kind at the federal level, although states have been using similar incentives for quite some time. The federal program encourages taxpayers to invest in economically depressed areas in exchange for significant — and sometimes permanent — tax breaks. Recently, the IRS released proposed regulations to clarify and provide guidance on various provisions of the program. These regulations are designed to give taxpayers confidence that the tax and other benefits of the program are worth investing in.
Those eligible to defer gains under the code section include individuals, C and S corporations, partnerships, trusts and estates. Taxpayers who want to take advantage of the program must do so by utilizing a qualifying intermediary to invest in one or more opportunity zones. These intermediaries, called Qualified Opportunity Funds, must keep at least 90 percent of their assets in “QOZ property.” QOZ business property, QOZ stock and QOZ partnership interests can all qualify as QOZ property.
Taxpayers can form their own QOFs, or they can invest in one that already exists.
Taxpayers that invest in a QOF can defer gains on the sales of their investments. They can also recognize permanent exclusions from gains if they hold the investment, or reinvest the proceeds into a different QOF, for periods of five to 10 years.
Capital gains need not necessarily be long term to qualify. In addition, unlike Code Section 1031 gain deferrals, only the gain is required to be invested and not the entire proceeds from the qualifying sale.
The reinvestment must occur within 180 days of the sale with certain exceptions.
The proposed regulations clarified many of the questions that taxpayers had about the program. A few of the most notable clarifications are listed below.
The program provides tax breaks only when the original use of their investments commence in a QOZ during the program’s eligibility period. In other words, if the assets are already being used within a designated opportunity zone, the taxpayer cannot reinvest those assets into a QOF to receive the tax benefit. However, the proposed regulations did allow for a few exceptions to this “original use” requirement.
Real property that has been vacant for at least five years prior to investment will qualify for the tax incentive.
The federal program encourages taxpayers to invest in economically depressed areas in exchange for significant — and sometimes permanent — tax breaks
If the taxpayer had not been using the property in a qualified manner before transferring the asset to the QOF, they can circumvent the “original use” rule.
Most funds will qualify as a QOF by holding and investing their tangible property (like real estate or equipment) in one or more opportunity zones. However, some QOFs will own business interests in corporations or partnerships instead. When a fund’s portfolio includes business interests, it can be difficult to ascertain if the underlying assets are truly being used for a qualifying purpose. The IRS states that as long as these business interests belong to “QOZ businesses,” they can count toward the 90 percent threshold mentioned previously, and the fund’s investors can still receive the benefits of this program.
According to the IRS, a “QOZ business” is any entity that utilizes substantially all of its tangible property in, generates at least 50 percent of its income from business in, and utilizes a substantial portion of its intangible property in, an opportunity zone. “Substantially all” means that at least 70 percent of the business’s tangible property must be in a qualified opportunity zone so that the business can retain its classification as a QOZ business.
Similarly, a substantial portion of a business’s intangible property must be used in an opportunity zone. According to the IRS, a business will satisfy this requirement when a specific subset of its working capital meets specific conditions.
Working capital that is held in cash, cash equivalents, or debt interests must be designated for the acquisition, construction, or substantial improvement of QOZ property; be reasonable when compared to other start-up businesses; and be spent within 31 months.
While the tedious rules and complex definitions may scare many away, the tax benefits from investing in a QOF can be quite lucrative. Potential QOZ investors should ask themselves the following:
- Do they have highly appreciated assets?
- Are they looking for a way to avoid capital gains?
- Are they willing to make a decade-long investment?
- Do they have interest in supporting local economies?
These are among the many reasons to consider the program. The combination of using a qualified Certified Public Accountant and investing in a quality QOF will result in a worthwhile investment.
Frank G. Sweeney is a partner with Klatzkin & Co. in Hamilton.