By: John Eagan
The Internal Revenue Service (IRS) recently issued significant guidance regarding the implementation of the 2017 Tax Act provisions involving opportunity zones and the potential for both capital gain deferral and capital gain exclusion for investments related to these zones. Under the 2017 Tax Act, certain low-income communities can be designated as “qualified opportunity zones” and, after a nomination process, the IRS announced that more than 8,700 communities in all 50 states, the District of Columbia and five U.S. territories (American Samoa, Guam, Puerto Rico, the Northern Mariana Islands and the U.S. Virgin Islands) received the designation.
Qualified Opportunity Zone Designation
Qualified opportunity zone designation can result in investment potential that is designed to promote economic development and job creation in low-income communities, with associated tax benefits available to investors. Under the legislation, qualified opportunity funds will be established to make investments in qualified opportunity zones. The funds are investment vehicles that can be structured either as a corporation, a partnership or a limited liability company (LLC) taxed as a corporation or a partnership.
A qualified opportunity fund must hold at least 90 percent of its assets in qualified opportunity zone property, which includes an investment in a domestic corporation, partnership or LLC in which substantially all of the tangible property that the business owns or leases is qualified opportunity zone business property. Qualified opportunity zone business property is tangible property used in a business that was acquired by the fund after December 31, 2017, is substantially used in a qualified opportunity zone and is property for which original use started with the fund or the fund substantially improves.
Benefits from a Tax Perspective
For investors, there are two main tax benefits:
- Investors can defer capital gain realized from a sale if they reinvest the proceeds within 180 days after the sale into a qualified opportunity fund. The gain deferred is equal to the amount invested in the fund, while a gain in excess of the amount invested in the fund is taxable under normal tax rules. The deferred gain is then recognized at either the date of disposition of the investment in the fund or December 31, 2026, whichever comes first. If the investment in the fund is held for at least five years, however, some of the deferred gain is excluded from income.
- Any appreciation in the fund after the investment date is excluded from gross income if the investment in the fund is held for at least 10 years.
This guidance issued by the IRS clarified certain aspects of the new legislation. First, the deferral and exclusion rules only apply to capital gain, not to ordinary gain. Second, the capital gain cannot result from the sale to a related party and the gain must have been recognized – absent the allowed deferral – on or before December 31, 2026. Third, the investment in a fund can be made by individuals, C-corporations and pass-through entities, such as LLC’s. Finally, in the case of improved real estate, the land and any existing improvements cannot satisfy the “original use” test, but substantial improvements to an existing building can be qualified opportunity zone business property.
The 2017 Tax Act limited the scope of like-kind exchanges to real property, so we would expect that personal property, previously exchanged for tax deferral purposes, might now be sold and reinvested into a qualified opportunity fund. Real estate development will also likely be a key aspect of qualified opportunity fund investments. In addition, short-term capital gain is currently taxed for federal income tax purposes at the same rate as ordinary income. One planning technique would be to sell assets – including stock or a carried interest – that result in short-term capital gain and move the sale proceeds into an investment that can result in deferral of income and possible exemption from tax.
It is clear that the legislation does provide substantial incentives to investors who would like to roll over proceeds from a capital gain transaction into a qualified opportunity fund, while at the same time addressing the challenges low-income communities have in attracting funds. The opportunity zone legislation can become an intermediary for connecting investors with capital to business opportunities in low-income communities.