As part of the Tax Cuts and Jobs Act passed at the end of 2017, Congress provided new tax benefits for investments in designated Opportunity Zones. While the specifics of the new law are still being ironed out, through enactment of further regulations, the Opportunity Zone program is worth a further look for investors seeking preferential tax treatment for capital gains.
Opportunity Zones, covering parts of all 50 states, the District of Columbia and five U.S. Territories, are designed to spur economic development by providing tax benefits for investors. Governor John Carney selected 25 census tracts across the State of Delaware as Opportunity Zones in April 2018. The designated Opportunity Zones are intended to spur additional private sector investment in economically-distressed properties across the State. Under the Act, prospective investors are incentivized to sell appreciated property and to reinvest the gains into qualified Opportunity Zone projects. The incentives consist of tax deferral on prior gains invested in a Qualified Opportunity Fund (QOF), as well as a potential step up in basis for the QOF investment.
Unlike the typical capital gain deferral available with a Section 1031 exchange, investors can now shield gains on a much broader class of investments, including not only real estate, but also sales of stocks and bonds, as well as partnership and LLC interests. There are three potential tax benefits of investing in an Opportunity Zone:
- a deferral of paying tax on any prior gain invested in a QOF until the earlier of the date the QOF is sold or exchanged, or December 31, 2026;
- a percentage reduction in the deferred gain, depending on how long the investment is held: a 10% reduction for QOF investments held longer than 5 years; and a 15% reduction for QOF investments held for more than 7 years; and
- with a QOF investment held for at least 10 years, an investor will pay no tax on the appreciated value of the investment in the QOF.
These new tax savings, coupled with the lack of other tax-deferral options for classes of investments outside of the real estate arena, provide incentives to investors seeking either to diversify their portfolios, or shield appreciation of investments from immediate capital gain taxation.
So, how can investors take advantage of these new tax savings? First, it is necessary to invest in a QOF. A QOF is an investment vehicle that is set up as either a partnership or a corporation for investing in eligible property located within a designated Opportunity Zone. Two or more partners or shareholders are required. A limited liability company can be used as a QOF, so long as it elects to be treated as either a partnership or a corporation for federal income tax purposes. There is no approval or action required by the IRS. Instead, the QOF self-certifies by filing Form 8996, which is attached to the entity’s federal income tax return.
Ninety percent of a QOF’s assets must be invested in Qualified Opportunity Zone Property, with this percentage tested in each tax year. Meeting this required percentage is critical, because failing to meet it will result in the loss of the tax deferral, as well as the imposition of a penalty.
For property to qualify as Qualified Opportunity Zone Property, it must be acquired after December 31, 2017 from an unrelated person and either: (1) the first use of the property is in the Opportunity Zone, or (2) there must be a “substantial improvement” of the property. In addition to real estate (land) itself, Qualified Opportunity Zone Property can include tangible property and buildings owned by and used in a trade or business of the QOF. Qualified Opportunity Zone Property may also include the stock or partnership interest in a Qualified Opportunity Zone Business (QOZB), if the stock or partnership interest is acquired after December 31, 2017. A qualified business is a business entity based in an Opportunity Zone with “substantially all” of its tangible business property qualifying as eligible property using the same rules and limitations discussed above regarding a Fund’s direct ownership of Qualified Opportunity Zone Property.
Property is “substantially improved” by a QOF (or a QOZB) if during any 30-month period after the property is acquired, additions to the tax basis of the property are made that equal or exceed the adjusted basis of the property at the time of acquisition. Based on proposed regulations, where land and a building are acquired together, the 100% addition to basis requirement applies only to the cost of the building, and not the cost of the land.
Excluded from the benefits of Opportunity Zone investments are certain “sin” business, such as private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, gambling establishments (including race tracks), or liquor stores. Although not specifically set forth in the Act, it is likely that regulations will prohibit leasing Qualified Opportunity Zone Properties such businesses, as well.
A map showing the location of Opportunity Zones within the State of Delaware, as well as additional information on the benefits of investing in Delaware, can be found here: https://business.delaware.gov/opportunity-zones/