Despite a weak fourth quarter for stocks, U.S. equities have experienced a record-long bull market since the financial crisis one decade ago. For investors who have enjoyed a long run of financial gains—and who are contemplating a rotation into other asset classes—the new federal Investing in Opportunity Act can provide a solution for protecting gains and maximizing the potential of future investment appreciation. This summary outlines the legislative and regulatory history of the Opportunity Zones program and discusses potential deal structures that would include qualified opportunity zones investments.
Legislative and Regulatory History
The opportunity zones investment program was created as part of the 2017 Tax Cuts and Jobs Act, and the program is intended to encourage investment in economically distressed census tracts across the country. Pursuant to the statutory provisions of the program, taxpayers with gains can make qualifying investments triggering a series of tax benefits, including immediate capital gain deferral, as well as the potential for additional gain forgiveness.
On October 19, 2018, the U.S. Treasury issued guidance regarding the Opportunity Zones program. Consisting of proposed regulations, a revenue ruling and responses to FAQs, and a tax return form for qualified opportunity funds, the guidance provides clarity on several key points. This initial guidance provided significant direction for potential investors, fund managers, developers, entrepreneurs and other market participants, many of whom sought clarification regarding the parameters of the opportunity zone program before deploying capital. That said, it is worth noting the October 19 regulations are only in proposed form at this point, and further changes may be made upon final adoption. In fact, the IRS has indicated additional guidance is in process. As of the date of this article, the October 19 proposed rules have not been finalized and additional Treasury guidance is forthcoming.
The U.S. Treasury and Internal Revenue Service provided an initial set of guidelines to define Qualified Opportunity Zones. Based on these guidelines, state governors nominated census tracts for Qualified Opportunity Zone designation. Each census tract had to meet the Low-Income Community requirement (median family income at or below 80 percent of Area Median Income or a poverty rate of 20 percent or greater). The designations were finalized in December 2018, and a full list of Qualified Opportunity Zones can be found online through the IRS website.
Opportunity Zones Transactions & Investment Structures
Under the opportunity zones legislation taxpayers can get (1) capital gains tax deferral, (2) partial forgiveness of the original gain, and (3) forgiveness of additional gains by making timely investments in Qualified Opportunity Funds (QOFs) which invest in Qualified Opportunity Zone Property (QOZ Property).
Any investor can create a QOF, but the investment capital must constitute capital gains from a previous sale of assets, which must be rolled into the fund within 180 days. Investors can own 100 percent of the QOF if they are not investing in a zone where they already own an existing property or business. If they already own an existing property or business, the investor is limited to 20 percent ownership of the QOF.
At this point there are generally three ‘tests’ as to whether an investment vehicle can qualify for the OZ program:
- Organizational Test. The investment vehicle must be organized as a corporation, partnership or LLC.
- Purpose Test. The investment vehicle must be organized for the purpose of investing in Qualified Opportunity Zone Property (QOZP).
- Asset Test. QOF’s assets must be comprised of at least 90 percent QOZP.
Potential Tax Benefits
Opportunity Zones provide three tax benefits for investors. First, investors may defer tax payment on prior capital gains invested in QOF until the date on which the investment is sold or exchanged or December 31, 2026, whichever comes first. Second, if the QOF investment is held for five years, there is a 10 percent exclusion of the deferred gain; if the QOF investment is held for seven years, the exclusion increases to 15%. Third, if the investor holds the QOF investment for at least 10 years, any additional gains on the original investment may be forgiven.
The required holding periods set forth in the legislation requires investors to be patient with their investment, and accessing the full range of tax benefits also requires investors to reinvest back into the property. The investor must substantially improve the property by making capital improvements at least equal to the original basis of the property at the time of acquisition, with land being excluded. For example, if an investor purchases a property for $1 million with $800,000 allocated to the structure, the investor must reinvest an additional $800,000 in capital improvements.
Opportunity Zones present a unique opportunity for investors to reinvest capital into neighborhoods and communities that have historically been neglected, while receiving substantial tax benefits; however, some question whether the legislation will have the positive community impact frequently referenced by advocates of the program. One concern is the risk of gentrification due to the new developments displacing residents who may not be able to afford to live in the revitalized neighborhoods. Others question whether these investments will guarantee jobs, incomes, housing and healthcare in the at-risk communities. Finally, some opportunity zones around the country were poorly chosen, while other obvious choices were left out.
Timing is everything with Opportunity Zones, and it is not necessarily on the investor’s side. To qualify for 15 percent exclusion of the deferred gain, an investor must place capital in a QOF by December 31, 2019. To qualify for 10% exclusion, the money must be placed by December 31, 2021. The investor then must be willing and able to hold the investment for at least ten years to eliminate or reduce their capital gains taxes. That kind of time horizon will likely steer some investors away from OZs.
On the other hand, the timing could not be better for this kind of vehicle, particularly given the historic asset appreciation seen in a variety of asset classes over the past decade. The Dow Jones Industrial Average has climbed approximately 300 percent since hitting its low in 2009, and the NASDAQ has rallied for an even greater percentage gain off of its lows. Similarly, real estate in many markets has regained all of its losses since the financial crisis, and in some areas, exceeded pre-crisis valuations. Opportunity Zones present those investors with large capital gains and a desire to rotate assets or asset classes a unique opportunity to do so in a tax-advantaged manner.
By Adam Charlsen, Partner, Husch Blackwell and Pat Morris
This article appeared in our company newsletter in March of 2019. Please click here to download the entire newsletter.