With contributions from Karen Spotts Bonner
It’s been said that the sign on the door of opportunity reads PUSH. If you have or will have long- or short-term capital gains from selling investments in real estate, securities or other appreciated assets — and you’re considering reinvesting in a business or in real estate — now’s the time to push. Or at least to consider pushing.
Why? The emergence of the Opportunity Zone. Created by the Investing in Opportunity Act (a part of the Tax Cuts and Jobs Act), it’s described by many as a once-in-a-lifetime tax benefit.
In brief, if you reinvest capital gains in real estate or other businesses located in an Opportunity Zone, you’ll defer (and potentially reduce) the tax on your reinvested gain. Then, if you hold the investment long enough, you’ll eliminate the tax on your new investment’s future appreciation.
Even better, if you’re interested in impact investments and socially responsible investments, you’ll also be doing a good thing.
What is an Opportunity Zone?
An Opportunity Zone is an economically distressed community that conveys preferential tax treatment to long-term investors under federal tax rules. In other words, it’s a tax-based economic development tool intended to spur investment and create jobs in troubled areas of the country.
To be designated an Opportunity Zone, a census tract must first be nominated by the state or other jurisdiction for this purpose and then be certified by the U.S. Treasury and the IRS.
For an area to qualify as an Opportunity Zone it must be characterized by either of the following:
a poverty rate of at least 20 percent, or
a median household income that is less than 80 percent of the median household income of its neighbors.
In total, there are more than 8,700 certified Opportunity Zones. They are located in every state, plus the District of Columbia and five U.S. territories. And they’re not all rural or inner-city — some of the locations just might surprise you.
What Are the Tax Benefits for Opportunity Zone Investors?
While Opportunity Zones were created by a federal tax law, there are implications for taxes levied at federal and state levels.
Federal Tax Benefits
Over time, you gain three significant federal tax benefits from your qualifying investment in a Qualified Opportunity Fund. The first two apply to the original capital gain that you reinvest. The third applies to the longer-term appreciation in the value of your Opportunity Zone investment.
Deferral You can defer the tax that would otherwise be due on the capital gains that arise from transactions between December 22, 2017 and before January 1, 2027 and that you reinvest in the Opportunity Zone. However, you can’t defer a gain if it arises from a sale or exchange with a related party.
The deferral extends until December 31, 2026 — or the date you sell or exchange the investment, if earlier. At that time, the amount of the underlying gain that you reinvested is taxable, less any exclusion as described below.
Exclusion If you hold your qualifying investment in the Opportunity Zone for more than five years, you can exclude ten percent of the deferred gain from federal capital gains tax. In other words, only 90 percent of the original gain is subject to tax.
If you hold your qualifying investment for more than seven years, you can exclude 15 percent of the deferred gain from federal capital gains tax. 85 percent of the gain is subject to tax.
Step Up in Basis If you hold your qualifying investment for more than ten years, its tax basis increases to its fair market value as of the date you sell or exchange it. In other words, you get a stepped up basis. That means your qualifying investment in the Opportunity Zone appreciates tax-free, similar to that of a Roth IRA investment. You won’t pay any capital gains tax on the appreciation when you sell or exchange it.
Importantly, if you sell your qualifying investment before the end of the ten-year period, you can roll it over into another qualifying investment.
State Tax Implications
Generally, if a state’s tax structure conforms to the federal Internal Revenue Code, the tax rules regarding investments in Opportunity Zones also apply at the state tax level. But that’s not always the case.
It’s further complicated by the fact that an Opportunity Zone investment can involve more than one state.
Then, certain states with conformity provisions specifically elected out of conformity when it comes to Opportunity Zones. In other words, you may not get any state tax benefit from your investment. Other states that do not typically conform to federal rules have adopted specific state-level tax benefits related to Opportunity Zones, which may or may not be similar to the federal rules.
Unfortunately, because the tax rules at the federal and state levels aren’t always in sync when it comes to Opportunity Zones, it may be necessary to separately track these investments at federal and individual state levels.
Sound simple enough? Here’s where it gets complicated.
What is a Qualified Opportunity Fund?
If you want your investment to qualify for the Opportunity Zone’s tax benefits, you must invest via a Qualified Opportunity Fund. Your investment must take the form of cash in return for an equity investment in the fund.
A Qualified Opportunity Fund is an investment vehicle established to invest in Qualified Opportunity Zone Property — i.e., eligible businesses and property that are located in a qualified Opportunity Zone. In fact, the fund must invest at least 90 percent of its assets in such Opportunity Zone Property (also known as the 90/10 test).
The fund must be created or organized in the U.S. as a partnership, a multi-member LLC that elects to be taxed as a partnership or a C or S corporation.
To qualify and remain qualified, the fund must self-certify annually using a form attached to its federal income tax return. The fund must tell the IRS both the first tax year and the first month that it wants to be treated as a Qualified Opportunity Fund.
Who Can Invest in a Qualified Opportunity Fund?
Investments in a Qualified Opportunity Fund, with accompanying tax benefits, are available to the following:
multi-member LLCs that are treated as partnerships or corporations for federal income tax purposes
C corporations, including regulated investment companies (RICs) and real estate investment trusts (REITs)
As a result, the gains to be reinvested can come from any number of sources — including real estate developers, affluent individuals and families and their family offices, venture capitalists and investment or private equity banks, even mutual funds.
What Are the Requirements Placed on Investors?
You must reinvest your capital gain in a Qualified Opportunity Fund during the 180-day period that begins when you sell or exchange the underlying asset for a gain — generally, the day the gain would be recognized for federal income tax purposes.
Further, you must actively make an election to defer your gain using a form you file with your tax return for the year in which the gain occurred.
If you are a partner, member or shareholder of an entity with a qualifying gain and that entity does not elect to reinvest that gain, you can elect to reinvest your portion of the gain at the individual level. In this case, you have a choice as to the start date of your 180-day period. Typically, the start date of the 180-day period is the final day of the entity’s tax year, but you can elect to use the actual (earlier) date on which the entity would have recognized the gain for tax purposes.
Importantly, if the 180th day falls on a holiday or weekend, there is no extension. That means the actual deadline falls on the last business day before the holiday or weekend.
If the date of the gain is near the end of the tax year and you haven’t made a final decision as to whether you want to make the election, it is important to extend the filing date of your tax return.
What Are the Requirements for a Qualified Opportunity Fund Investment?
There are a number of specific requirements placed on a Qualified Opportunity Fund, and this is where it really gets complicated.
A qualified investment in an Opportunity Zone Fund must be an equity investment made with cash. Debt instruments are not permitted.
The underlying gain being reinvested must be one that is treated as a capital gain for tax purposes, and that would be recognized if not for the Opportunity Zone investment. Only the gain portion of the transaction qualifies for preferential tax treatment and that gain cannot stem from a sale or exchange with a related person.
There are no limits placed on the amount of capital gains you can reinvest in an Opportunity Zone Fund. You can invest only part of your gain, invest multiple gains, make multiple investments over time, rollover gains into new fund investments — even invest more than your gain, although that is considered a separate investment that does not qualify for preferential tax treatment.
The 90 Percent Asset Test (90/10 Test) for Qualified Opportunity Zone Property
A Qualified Opportunity Fund must invest at least 90 percent of its assets in Qualified Opportunity Zone Property. This test is performed twice a year, either with reference to applicable financial statements or the cost of each asset. If the fund does not meet the test, it is subject to penalty.
Two Types of Qualified Opportunity Zone Investments
To satisfy the 90/10 test, the fund can choose either of two types of investments:
direct investments in Qualified Opportunity Zone Business Property where the fund itself conducts the business and owns the property
indirect investments in the equity (stock or partnership interests) of a corporation or partnership where the corporation or partnership conducts the business and the business owns the Qualified Opportunity Zone Business Property.
For indirect investments, each business must be an active trade or business located in an Opportunity Zone, must be a Qualified Opportunity Zone Business (or a new business organized for this purpose) and must satisfy a number of requirements.
Most importantly, substantially all of the tangible property that is owned or leased by the business must be Qualified Opportunity Zone Business Property. To satisfy this requirement, substantially all has been defined as at least 70 percent of the tangible property (the 70/30 test). Note that this test applies only to indirect investments.
As a result, if the Opportunity Fund invests via this type of indirect investment, 90 percent of the fund’s assets must be invested in the business itself, and then 70 percent of the business’ tangible property must be Qualified Opportunity Zone Business Property. Ultimately, only 63 percent of the indirect investment must be invested in the Qualified Opportunity Zone Business Property (90 percent x 70 percent). This compares favorably to the straight 90 percent required for direct investments as the lower percentage allows for more flexibility.
The following additional requirements apply to indirect investments — i.e., to Qualified Opportunity Zone Businesses:
50 percent or more of the business’ total gross income must be derived from the active conduct of a trade or business in the Opportunity Zone — potentially a limiting factor for many businesses with multi-state, national or international sales operations.
A substantial portion (not currently defined) of intangible property has to be used in the active conduct of the trade or business.
Less than five percent of the unadjusted basis of all property can be nonqualified financial property.
So-called sin or vice businesses — whether operated or leased — are excluded. For this purpose, such businesses are considered to include golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks, gambling facilities and any store for which the principal business is the sale of alcoholic beverages for consumption off premises.
Safe Harbor for Indirect Investments
The tax rules provide for a safe harbor in applying the nonqualified financial property requirement for indirect investments, in part because of the long planning and implementation periods required for many real estate projects.
With this safe harbor, during a period of up to 31 months — and if certain documentation and scheduling requirements are met — the Qualified Opportunity Zone Business may hold significant cash and other working capital necessary for the project without failing the five percent financial property test.
In other words, the Qualified Opportunity Zone Business has up to 31 months to invest your money in an Opportunity Zone. However, you begin deferring your underlying capital gain — and establish the start date for the additional tax benefits — as soon as you invest in the fund.
Qualified Opportunity Zone Business Property
The shared concept for both direct and indirect investments is Qualified Opportunity Zone Business Property, so the definition is critical.
Qualified Opportunity Zone Business Property is tangible property located in a qualified Opportunity Zone and used in a trade or business. Additional requirements include the following:
The property must have been purchased after December 31, 2017, although the later the date, the less likely the reinvested gains will be held long enough to qualify for certain tax benefits. This requirement is intended to ensure that there is a new investment made in the Opportunity Zone.
The original use of the property within the Opportunity Zone must begin with the business, although the property does not have to be new property. For example, the business can purchase used equipment located outside of the opportunity zone for use within the zone. Again, this ensures a new investment in the Opportunity Zone.
Alternatively, the business can buy used property within the Opportunity Zone — an older building, for example — as long as the business substantially improves it. A substantial improvement requires that the business spend more to improve the property than it spent to buy it, excluding the cost of any land. It’s often called doubling down since the basis must double. Further, that substantial improvement or doubling of basis must be made during any 30-month period after buying the property.
Substantially all of the use of the property must occur within the Opportunity Zone for substantially all of the business’ period of ownership. The meaning of substantially all as used here has not yet been established.
Types of Qualified Opportunity Zone Fund Investments Compared
|Fund is a business that directly owns Qualified Opportunity Zone Business Property||Fund owns equity interest in a Qualified Opportunity Zone Business|
|Subject to 90/10 asset test||Yes. 90% of fund’s assets must be Qualified Opportunity Zone Property||Yes. 90% of fund’s assets must be Qualified Opportunity Zone Property|
|Subject to 70/30 test||N/A||Yes. 70% of the business’ tangible property (owned or leased) must be Qualified Opportunity Zone
|Active trade or business requirement?||N/A||50% or more of gross income must be from active conduct of trade or business in the Opportunity Zone|
|Eligible for working capital safe harbor?||N/A||Working capital safe harbor allows business to hold cash for acquisition, construction and/or rehabilitation of tangible property during initial 31‑month period|
|Investments in sin or vice businesses precluded?||N/A||Investments in these businesses are not permitted|
How does an Opportunity Zone Investment Compare to a 1031 Exchange?
There are significant differences between the tax benefits that accrue from an investment in an Opportunity Zone versus like-kind property that qualifies for a 1031 exchange.
Among the major differences are that, for a 1031 exchange, only your real estate assets qualify and exchange must include the value of the asset and the gain. For an Opportunity Zone investment, all assets that give rise to a capital gain qualify and only the gain portion of the transaction must be reinvested.
The time horizon is another difference. For a 1031 exchange, the step-up in basis only occurs upon death. For an Opportunity Zone investment, the increase in basis occurs once the investment is held for more than 10 years.
|Opportunity Zone||1031 Exchange|
|Qualifying gain||Virtually any short- or long-term gain that is treated as a capital gain||Real estate only|
|Amount that must be reinvested||Gain portion only||Total sales price — including both the asset’s initial basis and gain|
|When reinvested gain is taxed||The earlier of when asset is sold or December 31, 2026||When (if) asset is sold|
|When appreciation of reinvestment is taxed||Stepped up basis after 10 years||Stepped up basis upon death|
|Depreciation recapture subject to tax as ordinary income||No, if held greater than 10 years||Yes|
The federal tax rules for Opportunity Zones are detailed and complex, and cannot be fully explained in this overview. Consult with a tax advisor before making any business or financial decisions based on this tax benefit. If you have additional questions about Opportunity Zones, give us a call.
Have questions about Opportunity Zones and how you might benefit?