Opportunity Zones: A Year Later!
One of the last provisions tucked into the 2017 Tax Cut and Jobs Act (“TCJA”) was IRC Section 1400Z, which created the federal Opportunity Zones. There are approximately 8,700 census tracts approved by the Treasury within the USA, including Washington, DC, and Puerto Rico. The primary incentive behind Opportunity Zones is to drive investment in America’s low income communities by providing (1) deferral of current capital gains taxes, (2) a reduction in the amount that would be taxable as a capital gain if certain holding periods are satisfied, and (3) elimination of capital gains taxes for any gains realized above the original invested amounts, if held for at least 10 years.
Most taxpayers concentrated on the other major provisions of the TCJA, such as tax cuts and state tax deduction limitations. However, after the dust settled and once the act passed, taxpayers started to dig deeper for ways to maximize benefits , including Opportunity Zones.
To qualify, a taxpayer must roll over a capital gain into a Qualified Opportunity Zone Fund “(QOZF”) within 180 days of the capital gain being triggered. If the deferred gain within the rolled over investment is held for five years in the QOZF, taxpayers are entitled to a 10% reduction in the capital gain rate (through increased basis). If the QOZF is held for seven years, there will be a 15% reduction in the capital gain tax. The most interesting part of the Opportunity Zones provision calls for a 100% gain exclusion on the upside value if a QOZF investment is held for 10 years. Regardless, the roll over gain into a QOZF will be taxed on December 31, 2026, unless it is sold earlier.
- Treasury released two sets of proposed regulations following passage of the TCJA. The first set, released in October 2018, was very taxpayer-friendly and included the following provisions, among others: Flow-through entities’ 180 day deferral period begins with the entity’s tax year– end, for capital gains from non-business assets.
- If a QOZF investment is sold, the taxpayer has another 180-day period to roll over those proceeds into a new QOZF.
- Working Capital “Safe Harbor” is 31 months for a Qualified Opportunity Zone Business (“QOZB”) to deploy the capital.
- Substantial improvements for non-original use property for QOZ property must be completed within 30
The second set of proposed regulations was released in May 2019 to amend language which was keeping significant capital on the sidelines. The main provisions are as follows:
- Debt financed distributions are allowed if there is basis and the transaction is not a disguised
- Working capital safe harbor can be extended if delay is caused by a government
- A building that has been vacant for five years or more is considered Original Use
Many of Marcum’s real estate clients, which include developers, private equity and hedge funds, have invested in projects located in Opportunity Zones, and with the release of the second set of regulations, capital continues to flow into these projects.
For example, some cannabis investors were initially excited about the possibilities of rolling their capital gains into a cannabis business that was owned by a valid QOZF. Since the cannabis industry was not included on the original “sin” business list, there was initial optimism that was subsequently diminished when Treasury Secretary Mnuchin testified before Congress that cannabis businesses were not in the spirit of the law.
The real estate side of Opportunity Zones has received most of the spotlight over the last two years. However, another possible opportunity that could generate higher yields under the Opportunity Zone program is often overlooked. That is the provision allowing for the deferral as well as the elimination of the capital gain on the upside when investing in a QOZB. Investing in a QOZB has its own set of rules but could provide a greater upside when compared to the real estate option. For example, what if Facebook were originally located within a QOZ when it went public? Could some of the early stage investors have potentially cashed out with a federal tax-free capital gain on sale?
Similar situations are arising in markets such as San Jose, where buildings are being leased to “start ups” within the city’s QOZs, with the hope of luring these companies from Silicon Valley, which is just 20 minutes away.
The other option for taxpayers to get involved with Opportunity Zones is through direct investment into managed funds. Most of the major brokerage houses and money center banks have established their own Opportunity Zone funds which allow taxpayers to rollover their capital gains directly. The funds are designed to provide some liquidity to taxpayers in late 2026, in order to pay the capital gains taxes that will be coming due. It is a perfect solution for taxpayers who do not want to manage their own QOZF and the burdens that come with it.
The other issue to consider is the state tax treatment of a QOZF investment. Most states have conformed to the new federal law either fully or on a rolling scale. However, several states, including California, Massachusetts, Mississippi and North Carolina, have not yet conformed. Residents of these states will be required to pay state income tax on the gain portion that is being deferred for federal purposes.