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Opportunity Zones – Some Basic Information for State & Local Governments
What is an Opportunity Zone?
An Opportunity Zone is a designated geographic area within each state. Equity investments made in businesses located in an Opportunity Zone are eligible for special federal income tax benefits pursuant to a special provision enacted as part of the Tax Cuts and Jobs Act enacted by Congress on December 22, 2017. The zones, which are based on economically-distressed U.S. Census Tracts, were selected by the Secretary of the Treasury in June 2018; a list of zones by census tract number can be found at Opportunity Zone Census Tracts and an interactive map showing them by location is included at Opportunity Zone Map. Last week, the Treasury Department published comprehensive regulations and a Revenue Ruling that were designed to answer certain basic questions regarding the administration of Opportunity Zones.
What special federal income tax benefits are available for an investment in an Opportunity Zone?
Taxpayers with appreciated assets that would otherwise be subject to capital gains taxes can sell those assets and reinvest the proceeds in an Opportunity Zone business or in an Opportunity Zone fund (a “fund” that invests in one or more Opportunity Zone businesses). If the reinvestment occurs within six months after the sale of the original asset, the tax due on capital gains on that sale is deferred. In addition, part of the current and future appreciation in the new investment within the Opportunity Zone can escape tax entirely. The investment in the Opportunity Zone business is made by acquiring stock in a corporation or a partnership interest in a partnership.
Are there any limitations on the type of appreciated assets that are eligible for this special tax deferral treatment?
Generally, no. Most assets that are capital assets for a taxpayer that, if sold, would result in long-term or short-term capital gain are eligible.
How long is the gain deferred? What portion of the gain can escape tax entirely?
The amount invested in the Opportunity Zone business or Opportunity Zone fund is treated as having a tax basis of “$0.” Subject to certain exceptions, the original gain that is deferred must be recognized on the earlier of (1) the date the investment in the Opportunity Zone business or Opportunity Zone fund is sold or disposed of or (2) December 31, 2026. In addition, the deferred gain must be recognized if the investment in the business or the fund ceases to meet the requirements for an Opportunity Zone investment.
If the investment is held for 5 years, the taxpayer’s “tax basis” in the investment is increased by 10%; if held for 7 years, it is increased by an additional 5%. Finally, if an Opportunity Zone investment is held for at least 10 years, the taxpayer can sell it at any time before January 1, 2048, without recognizing any additional taxable gain.
This is complicated, can you provide a simple example that illustrates?
Assume a taxpayer “T” owns appreciated stock in Corporation C. The C stock has a fair market value of $100,000 and T’s tax basis in her C Stock is $10,000. So, if T sells the C stock for cash in a normal transaction, she has a capital gain of $90,000.
On December 31, 2018, T sells the stock for $100,000. She uses $10,000 of the sale proceeds to fund a January vacation in the Bahamas and invests the balance ($90,000) in a Qualified Opportunity Zone Fund (“QF”) on June 30, 2019 (not more than 6 months following the sale date). Because of the new Opportunity Zone law, the tax basis of T’s investment in QF is $0, but she pays no tax on the gain arising from the sale of the C stock in 2018 (and of course was able to enjoy that vacation in the Bahamas as well)!
T continues to hold her investment in QF, and QF continues to qualify under the Opportunity Zone law. On June 30, 2024 (5 years after the initial investment in QF), T’s tax basis in QF automatically increases to $9,000 (10% of the $90,000 originally invested). On June 30, 2026, T’s tax basis in QF increases to $13,500 (15% of the $90,000 originally invested). On December 31, 2026, T must recognize capital gain of $76,500 on her investment in QF (and she pays federal income tax based on the capital gain tax rates then in effect). This occurs even if T continues to hold her investment in QF, but her tax basis in QF is now $90,000.
Sometime between June 30, 2029 and December 31, 2047, T decides to sell her investment in QF for $250,000. T can elect to treat her basis in QF as equal to its fair market value on that date and pay no federal income tax on the capital gain of $160,000 ($250,000 sale price less $90,000 basis). Assume, however, that the market value of QF declined and T sells her investment for $50,000 instead of $250,000. T can forego electing to treat her basis as equal to the fair market value in QF and claim a $40,000 tax loss on the date of the sale.
How do Opportunity Zones fit into a typical development or redevelopment project financing?
The Opportunity Zone legislation is best thought of as a way of obtaining additional “low-cost” equity capital that is needed to acquire, construct, equip or redevelop a commercial project that will be located in an Opportunity Zone. The Opportunity Zone investor can obtain the federal income tax benefits offered under the new law only if he or she reinvests amounts corresponding to the capital gain in shares of stock or a partnership interest (the benefit cannot be derived by “loaning” the money to finance the project). The capital provided by these investors should be “cheaper” because an investment in the Opportunity Zone is entitled to special federal income tax benefits that permit the investor to realize the same “after tax” economic return on the investment even if the amount realized from the investment (whether from profit distributions, the sale of the stock or partnership interest, or the liquidation of the corporation or partnership) is less than what a conventional equity investor would demand.
While some individuals and businesses have already been using the Opportunity Zone law to directly invest proceeds in an Opportunity Zone business, many more potential investors have been waiting for written guidance from the IRS before selling appreciated assets and reinvesting the proceeds in an Opportunity Zone fund that pools invested dollars and makes investments in multiple Opportunity Zone businesses. The IRS guidance was published last week, and we now expect to see Opportunity Zone investors participate in most redevelopment projects located in an Opportunity Zone.
While the exact financial and business structures will likely evolve over time, we anticipate that developers planning new projects located in Opportunity Zones (e.g., residential rental developments, hotels, shopping centers, mixed-use developments or factories) will all seek out Opportunity Zone investors.
These investors might be individuals or businesses that directly hold appreciated assets that they will sell and reinvest as partners or shareholders in the Opportunity Zone business. Or, the investment might be made by a corporation or partnership “fund” comprised of numerous individuals and/or businesses that have sold appreciated assets and reinvested the proceeds in the fund, which has agreed to invest in many Opportunity Zone projects in multiple Opportunity Zones and to monitor and administer those investments. In either case, the “investment” would be made in exchange for an equity interest in the developer-controlled entity, and the investment proceeds would be spent to acquire, construct, improve or rehabilitate tangible and/or intangible property that would be used in the new business (e.g., the apartment complex, the commercial shopping center, the mixed-use development or the factory).
For each redevelopment project, we expect the Opportunity Zone equity capital to be added to other available funds or subsidies (e.g., conventional equity, private loans, taxable or tax-exempt bonds, federal and/or state tax credits, property tax abatement, grants, etc.) to create the overall “financing package” for the project. However, the hope and expectation is that the special federal income tax benefits available to these new Opportunity Zone equity investors will dramatically increase the supply of available equity and that these new equity investors will accept a lower economic return when compared to traditional equity investors in the project. If this occurs, more economic redevelopment projects in Opportunity Zones should become economically feasible.
You mentioned that investment in the Opportunity Zone business or the Opportunity Zone fund has to meet certain requirements – what are they?
There are very few limitations on the type of business that can use Opportunity Zone equity, so long as the business itself is “actively conducted.” Investments in rental real estate (including residential rental real estate) are generally permitted so long as the business performs some services in connection with the rental of the assets. The federal tax rules related to this requirement are not unique to Opportunity Zones and can usually be met by most businesses that lease real estate or personal property. Manufacturing and most retail or wholesale service businesses also can use Opportunity Zone equity to acquire real property and personal property (both tangible and intangible) that will be used in the business.
However, certain “disfavored” businesses are not permitted. Examples include a private or commercial golf course, a country club, a massage parlor, a tennis club, a skating facility (including roller skating, skateboard, and ice skating), a racquet sports facility, a hot tub facility, a suntan facility, a racetrack, or liquor store or other retail store the principal business of which is selling liquor for off-premises consumption.
To qualify as an Opportunity Zone fund, at least 90% of the entity’s investment must be made in a qualified Opportunity Zone business. To qualify as an Opportunity Zone business, at least 70% of the tangible assets owned or leased by the business must be used in an Opportunity Zone. Generally, these requirements must be met each year or the tax deferral benefit to the Opportunity Zone investor will be lost. Further, the proceeds of an investment in an Opportunity Zone fund must be invested or reinvested in a qualified business within a designated time.
There are more specific rules and limitations, but if a particular business or type of project is contemplated for an Opportunity Zone, it is important to determine at the outset whether it can satisfy the tax requirements over an extended period of time – ideally for at least 10 years.
How is this provision “relevant” for State and local governments that are trying to “jump start” economic development projects?
It appears that the deferral and nonrecognition provisions of the law will be attractive to certain investors so long as the Opportunity Zone business can generate a reasonable overall economic return. Unlike some Federal tax credits (such as the Federal New Market Tax Credit), it seems unlikely that most investors will be interested in investing in an Opportunity Zone business or an Opportunity Zone fund if no economic return (other than the tax benefit) is expected. However, for certain redevelopment projects, the ability to pair Opportunity Zone equity capital with other existing tax benefits offered by State and local governments (e.g., tax-exempt financing, tax abatement, tax increment financing, special tax districts and state or federal tax credits) could make an otherwise marginal project viable or reduce the amount of State and local tax incentives necessary to make the project economically attractive to investors.
Congress structured the Opportunity Zone legislation in a way that permits most business investment within an Opportunity Zone to take advantage of the special federal income tax benefits previously described. But obviously not all economic development within an opportunity zone will provide the same overall benefit to the local community. Ideally, State and local governments will want to work with their professional representatives to prioritize and structure the State and local tax incentives they can provide in a way that encourages Opportunity Zone investment in the new capital projects that produce the greatest overall public benefit.
Posted: Oct 29, 2018