The Tax Cuts and Jobs Act of 2017 (TCJA), enacted Dec. 22, 2017 and included in Internal Revenue Code §1400Z, provides tax incentives for an investment in a qualified Opportunity Zone, the goal of which is to facilitate development in targeted low-income, economically distressed communities. Opportunity Zones provide the investor with a temporary deferral of capital gains income from a prior investment (Prior Investment), which need not have been for a charitable endeavor, if all or part of the capital gain is reinvested in a Qualified Opportunity Fund (Opportunity Fund). This is intended to encourage investments used to start businesses, develop abandoned properties or provide low-income housing in the Opportunity Zone.
The legislation provides investors with an opportunity to receive (a) a potential appreciation in the Opportunity Zone Investment (OZ Investment), (b) a temporary deferral of capital gain recognition from the Prior Investment, (c) a potential step-up in the investor’s basis in the Opportunity Fund, and (d) a possible permanent exclusion of capital gain from the Opportunity Fund investment if the holding period is at least 10 years and the investor retains the investment for at least five years. To gain the benefits, an investor with a capital gain has 180 days from the sale or exchange of the Prior Investment to invest all or part of the gain from the Prior Investment in an Opportunity Fund.
Capital Gain Deferral
The Opportunity Fund must use the investment to acquire Qualified Opportunity Zone Property (Qualified Property), which is an interest in the underlying business or property in an Opportunity Zone. The investor can hold the interest for as long as the investor desires or as agreed to with the Opportunity Fund, but if the investor sells or exchanges the interest in the Opportunity Fund before Dec. 31, 2026, the investor will immediately recognize the deferred capital gain. However, if the investor holds the interest for at least five years, the investor receives a basis allocation that will offset some of the original capital gain, and the basis allocation increases if the holding period is at least seven years. Nevertheless, the investor’s capital gain deferral ends on Dec. 31, 2026, and even if the investment is still outstanding at that time, the deferred capital gain must be recognized on the investor’s 2026 tax return. In the event the investor holds the interest in the Opportunity Fund for at least 10 years, the investor’s basis in the Opportunity Fund increases to the investment’s fair market value at that time, so that any appreciation in the value of the investment through 2028 would be excluded from income.
An open question is what happens if the OZ Investment is sold at a loss and the investor must also recognize the capital gain from the Prior Investment. If the OZ Investment was $10 million and is sold for $4 million, the investor would be obligated to pay tax on the $10 million capital gain from the Prior Investment and would not be able to offset it by the $6 million loss from the OZ Investment.
Opportunity Funds can be organized as corporations or partnerships that hold at least 90 percent of their assets in Qualified Property; this is determined by the percentage of Qualified Property held in the Opportunity Fund on the last day of the first six-month period of the Opportunity Fund’s taxable year and on the last day of the Opportunity Fund’s taxable year. If the Opportunity Fund does not meet the 90 percent requirement, it is required to pay a penalty for each month that it fails to qualify. The amount of the penalty is equal to the excess of (a) the amount equal to 90 percent of the aggregate assets and (b) the aggregate amount of Qualified Property held by the Opportunity Fund, multiplied by the underpayment rate established in IRC§6621(A)(2). An Opportunity Fund can self-certify by attaching a form (that will be available this summer) to the taxpayer’s federal income tax return for the taxable year.
The foregoing provisions create a potential problem in that the TCJA describes partnerships and corporations but not limited liability companies. Considering all the advantages for LLCs as an ownership vehicle contained in TCJA, could this have been an oversight by Congress, or did the authors of the legislation believe that they did not have to include LLCs because LLC are taxed as partnerships and have the limited liability of corporations? Or are LLCs an inappropriate investment vehicle for Opportunity Zone investments? Accordingly, prior to using an LLC, a fund should consider obtaining a ruling from the Internal Revenue Service (IRS).
Qualified Property includes: (a) qualified Opportunity Zone stock, which is stock in a domestic corporation acquired by the Opportunity Fund after Dec. 31, 2017, at its original issue, solely in exchange for cash, and the corporation must be a qualified Opportunity Zone business (Qualified Business) for substantially all of the Opportunity Fund’s holding period of such stock; (b) a qualified Opportunity Zone partnership interest, which is a domestic partnership interest acquired by the Opportunity Fund after Dec. 31, 2017, solely in exchange for cash, and the partnership must be a Qualified Business during the Opportunity Fund’s holding period of such interest; (c) a qualified Opportunity Zone Business Property, which is tangible property used in a trade or business of an Opportunity Fund that was acquired after Dec. 31, 2017, and the original use of such property in the Opportunity Zone commences with the Opportunity Fund or the Opportunity Fund substantially improves the property, and the use of such property was in an Opportunity Zone during substantially all of the Opportunity Fund’s holding period for the property. Qualified Property would be treated as substantially improved by an Opportunity Fund only if during the 30-month period beginning after the date of acquisition, the additions to the basis of such property in the hands of the Opportunity Fund exceed the adjusted basis of such property at the beginning of the 30-month period.
A Qualified Business is a trade of business in which substantially all of the tangible property owned and leased by the taxpayer is Qualified Property, which is tangible property used in the trade or business of the Qualified Business. Moreover, at least 50 percent of the Qualified Business’s gross income must be derived from the active conduct of such business and the average of the aggregate unadjusted bases of the Qualified Property attributable to “nonqualified financial property” is less than five percent. A Qualified Business cannot be engaged in private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. In the event tangible property ceases to be Qualified Property, it will continue to be treated as Qualified Property for the earlier of: (i) five years after the date it ceases to be qualified, or (ii) the date on which it is no longer held by the Qualified Business.
Opportunity zones are census tracts that are low-income communities, designated as such by the governor or CEO of each state, Washington, D.C. or U.S. possession, who were required to provide particular consideration to areas that: (1) are currently the focus of mutually reinforcing state, local, or private economic development initiatives to attract investment and foster startup activity; (2) have demonstrated success in geographically targeted development programs; and (3) have recently experienced significant layoffs due to business closures or relocations. The Treasury Department has 30 days after receipt of a nomination to determine whether the census tracts would qualify as an Opportunity Zone. The number of Opportunity Zones may not exceed 25 percent of the number of low-income communities in the state. For example, New York Governor Andrew Cuomo has recommended 514 census tracts for designation as Opportunity Zones. In addition, governors also may designate “population census tracts” that are not low-income community census tracts if (a) the tracts are contiguous with Opportunity Zones, (b) the median family income does not exceed 125 percent of the contiguous tract and c) no more than five percent of the designated Opportunity Zones are population census tracts.
There is a similarity between Opportunity Zones and the New Markets Tax Credit (NMTC), which is a tax credit equal to 39 percent of the investment taken over a seven-year period, rather than a temporary deferral of inclusion in income of capital gains and the resulting deferral of tax on the capital gain. However, the Treasury Department’s authority for the NMTCs has to be periodically reauthorized by Congress, which is not the case with Opportunity Zones.
In considering investments in Opportunity Zones, timing is key because the investment must occur within 180 days after an investor obtains a capital gain, which does not provide a great deal of time to consider alternate investment strategies. Moreover, since the tax benefits increase based on the time the investment is held, there is an incentive to liquidate capital gains currently and invest in an Opportunity Fund.
Stuart M. Saft is a partner at Holland & Knight and head of the firm’s New York Real Estate Practice Group.