Through the new tax law, the Tax Cuts and Jobs Act (TCJA), an economic incentive program has been enacted to help prop up and foster growth in certain low-income communities. These communities are typically the hardest hit by job layoffs due to closure and/or relocation of vital local businesses.
As of December 22, 2017, governors of all 50 states have been able to designate their impoverished communities that meet specific criteria as Opportunity Zones. Outside businesses are incentivized to establish a presence in these communities with an infusion of capital and investment. Since its inception throughout the entire United States, more than 8,000 of these communities in need have been given the Opportunity Zone designation.
Opportunity Zones entice outside investors and businesses by providing a couple of lucrative tax incentives. Deferring gains with the possibility to reduce them by up to 15% is among the first tax incentive. Second, investors who stay true to rigorous guidelines can exclude entire gains from the sale of their investment in Opportunity Zones, assuming certain conditions are met. To maximize returns, investors must adhere to strict timing and complex structuring requirements established by the TCJA.
Timing is a significant component to maximizing the benefits of Opportunity Zone investments. Initially, any taxpayer who recognizes capital gains (e.g., individuals, partnerships, corporations) has, with one exception, 180 days from the sale date to reinvest their gain into a Qualified Opportunity Zone Fund (QOFund). Owners of flow-through entities that choose not to reinvest their gains have the option to reinvest the passed down gain either 180 days from the flow-through entity's tax year-end, or 180 days from the date of sale if the owner is privy to such information. The tax recognition of these reinvested gains will be deferred until December 31, 2026, or until the asset sold, whichever arrives sooner. Taxpayers electing to defer their gain will indicate so on their current year tax return by filing IRS Form 8949, Sales and Other Dispositions of Capital Assets.
In addition to deferring their gains, investors who hold their interest in the QOFund for a certain amount of time can reduce the amount of deferred gain that will eventually be recognized. Investors who hold their asset for five years from the date they invested in the QOFund, can reduce their deferred gain by 10%. In seven years, the deferred gain be reduced by an additional 5%. So, only 85% of deferred gains reinvested in a QOFund in calendar years 2018 and 2019 will have to be recognized on December 31, 2026.
Deferring and potentially only having to recognize 85% of gains is one incentive available to investors of Opportunity Zones. The second and possibly most enticing incentive is the possibility for investors to exclude all of their gain from the sale of their investment in a QOFund. If held for at least 10 years from the date the deferred gains were reinvested in the QOFund, investors may elect to increase their basis, which by this time will equal the amount of gain deferred initially in the QOFund up to fair market value once sold, eliminating any gain. In the unfortunate event where fair market value is less than the taxpayer’s basis, losses may be recognized. Successful Opportunity Zone projects have the potential to yield substantial returns due to the unlimited gain exclusion.
Structuring of the Opportunity Zone projects will take some planning. A QOFund must be set up as a corporation or partnership. The entity's assets must consist of 90% of Qualified Opportunity Zone Property (QOProperty). This can either be Qualified Opportunity Business Property (QOBusiness Property), direct ownership, or the stock and/or partnership interest of a Qualified Opportunity Zone Business (QOBusiness). This, in turn, will ultimately need to own QOBusiness Property—indirect ownership. In either basic ownership scenario or direct vs. indirect, QOBusiness Property must be owned. To qualify as such, the business property must be located in a designated Opportunity Zone and the business property must either have originated with the QOFund or the basis of the original property must be improved upon by double the cost of acquisition within a 30-month period beginning after purchase. QOFunds that fail the 90% test will be assessed a monthly penalty and will have a five-year grace period to rectify the issue.
Investors interested in taking advantage of the tax incentives available for Opportunity Zone investments must be aware that only reinvested gains are eligible for deferral and exclusion. Any additional contributions to the QOFund will be considered as a separate interest and will be taxed accordingly. Setting up QOFunds can be challenging, and this article only broaches the basics. There are also lingering questions and concerns that the Treasury Department will still need to clarify. Luckily, they have acknowledged this and plan to address in future proposed regulations.
For a current list of designated Opportunity Zones, please visit the U.S. Department of the Treasury's website at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
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