Opportunity Zones (or OZs) may be the most talked-about provision of the Tax Cuts and Jobs Act of 2017. There are many twists and turns on the yellow brick road to completing an OZ project. This article sets forth the underlying rationale of the OZ program, its principal tax benefits, an overview of the basic requirements for making an eligible investment, and certain common problems encountered by taxpayers seeking to take advantage of OZs. In particular, we emphasize the continued availability of the program even if you aren’t prepared to set off for the Emerald City right away.
Purpose of the Program
In the years following the Great Recession, certain segments of the economy have enjoyed sizable increases in asset valuations, while certain regions of the country are still trying to recover from the 2008 financial twister. The OZ program is intended to encourage taxpayers to sell appreciated assets and reinvest the resulting gains into economically distressed areas. While prior tax incentives meant to spur investment in distressed areas seem to have been swept away to some magical land to never be heard from again, the Opportunity Zone program continues to drive considerable investment due to (i) nearly unprecedented tax benefits and (ii) the diverse and expansive set of investible qualifying zones.
Principal Tax Benefits
The Opportunity Zone program provides three Federal income tax1 benefits to taxpayers who have realized capital gains:
- If you reinvest your capital gains in a Qualified Opportunity Fund (see below), your Federal capital gains taxes on the reinvested capital will be deferred through 2026.
- If you invest in 2019 and hold the Qualified Opportunity Fund investment through 2026, 15% of your capital gains tax will be eliminated; if you invest in 2020 or 2021 and hold the investment through 2026, your capital gains tax will be reduced by 10%.2
- If you hold your Qualified Opportunity Fund investment for ten years, you can later sell it without paying any Federal tax.3
Principal Tax Requirements
To receive the aforementioned tax benefits, you must first realize a capital gain from the sale of an asset to an unrelated third party. Next, typically within 180 days following the sale, the capital gains must be invested in a Qualified Opportunity Fund (or a "QOF").4 In most circumstances, a QOF is an LLC that elects to be treated as a QOF for tax purposes and that is formed for the purpose of making an investment in an opportunity zone.
The QOF must invest in "QOZ Property;" in fact, 90% of the QOF's assets must be QOZ Property. The QOF must test its assets semi-annually and use the average of the two testing periods to determine whether it satisfies the 90% QOZ Property threshold for the year in question. QOZ Property can either be (i) tangible business property located in an opportunity zone that is either "Original Use" property or "Substantially Improved" property acquired after December 31, 2017; or (ii) a QOZ Business Entity (see below). In order to satisfy the Original Use test, the tangible property must (i) be new construction, (ii) have been vacant for the past five years or (iii) never previously used in the Opportunity Zone.
Tangible property satisfies the Substantial Improvement test if the QOF spends an amount equal to the adjusted basis of such property upon improvements to the property within a 30-month period. In the case of real estate, only the basis of the buildings and other structures is relevant for purposes of determining whether the property has been Substantially Improved. For example, assume that a QOF acquires an existing Kansas farm for $10M, the underlying land is worth $6M and the farmhouse is worth $4M; the QOF would need to spend $4M on improvements to the farmhouse in order to satisfy the Substantial Improvement test. The value of the land can be disregarded for purposes of the Substantial Improvement test. So long as the land is used in a trade or business, it should qualify as tangible QOZ Property.
In lieu of, or in addition to, investing in tangible property, the QOF may invest in a QOZ Business Entity. A QOZ Business Entity is a corporation or tax partnership if, amongst other requirements, (i) at least 50% of its total gross income is derived from the active conduct of a trade or business in an Opportunity Zone, (ii) at least 70% of its property is tangible QOZ Property5, (iii) it doesn't operate a casino, massage parlor, golf course, country club, hot tub facility, suntan facility, racetrack or other gambling facility, or any store the principal business of which is the sale of alcoholic beverages for off-site consumption, and (iv) no more than 5% of its property is non-qualified financial property.
Common Characters Found on the Yellow Brick Road to OZ
The Lion: Cash is Not King (or QOZ Property)
Cash held by a QOF is not QOZ Property and could cause the QOF to fail to meet the 90% QOZ Property requirement. Treasury regulations permit a QOF to disregard any cash contributed to the QOF within the six month period preceding a particular testing date. However, if the Opportunity Zone project has a longer investment period (e.g., a real estate project that will be developed over a multi-year span), the six month exemption period may be insufficient.
Fortunately, QOZ Business Entities can take advantage of the "reasonable working capital" exception which permits them to count cash as QOZ Property. In order to qualify for this exception, a QOZ Business Entity must have a written plan pursuant to which it will spend the funds over a period of up to 31 months. Accordingly, if you have the courage to take on a long-term project, operating the project through a QOZ Business Entity may be advisable.
The Tin Man: Lacking the Heart Needed for the Substantial Improvement Threshold
Issues with satisfying the Substantial Improvement threshold most commonly arise in the context of real estate projects. As noted above, in order for existing real estate structures to count as QOZ Property, you must spend an amount equal to your adjusted basis in the structures upon improvements to them within a 30-month period. If this is a problem for your project, have heart, as there may be a solution.
You are permitted to choose when the 30-month period begins. Additionally, the Internal Revenue Code provides generous expensing provisions that taxpayers may use to reduce the adjusted basis of real estate structures. You can use the timing flexibility and the expensing provisions to reduce the amount of expenditures necessary to satisfy the Substantial Improvement threshold. This strategy is best illustrated through the following example. In 2019, you acquire real property through a multi-member LLC. This acquisition is likely outside of a QOF structure. The LLC uses the tax code's expensing and bonus depreciation provisions to reduce the basis of the real property improvements on its 2019 tax return. On January 1, 2020, the LLC's basis in the improvements is significantly lower than it was on the acquisition date. The QOF now invests in the acquirer LLC and begins the 30-month Substantial Improvement window.
Alternatively, if deferring renovations does not solve the problem (or is not feasible from a business perspective), you can acquire real property outside of a QOF and then lease the property into the QOF structure. Unlike property owned outright, property which is leased need not be Substantially Improved.6 To many taxpayers, the most significant tax benefit of an Opportunity Zone investment is enjoying the Federal capital gain exclusion upon the sale of an investment held for ten or more years. To maximize this benefit, one must consider how to structure the lease in order to ensure that the QOF-lessee controls the property and has an asset with marketable value (without going afoul of the leased property rules).
The Scarecrow: If I Only Had a Brain Trust
The regulatory framework behind the OZ program is complex and can feel overwhelming to those who unexpectedly find themselves in this strange new land. However, in toto, OZs represent a rare opportunity to reposition capital in a tax-efficient manner that cannot be ignored. Given the regulatory complexity, it is imperative that you assemble a team of advisors including tax and real estate attorneys, accountants, and possibly brokers and valuation experts. Most importantly and contrary to many rumors, OZs are not going away at the end of 2019 and their advantages continue. Fortunately, we can help you build a strong team that will help you spot any flying monkeys as you follow the yellow brick road to OZ.
1 State income tax benefits are also available to investors in certain states; California does not currently provide any state income tax benefits. However, investments made in California or by California investors are eligible for Federal income tax benefits.
2 Legislation is under discussion that would extend the 15% reduction in deferred gains for investments made in 2020. Additional amounts of deferred gain may ultimately be excluded upon the conclusion of the deferral period.
3 A common point of confusion is the 10-15% reduction in deferred capital gains taxes versus the total elimination of future capital gains taxes if a QOF investment is held for 10 years. Please keep in mind that the 10-15% reduction applies to capital gains realized and deferred through 2026; while the total elimination of future capital gains applies to tax on future appreciation of the QOF investment. For example, if you realize a $4M capital gain and invest that amount into a QOF in 2019, the capital gains tax on the $4M gain is deferred through 2026 and reduced by 15%. If you hold your investment in the QOF for 10 years, you can sell it and pay no tax on that future sale.
4 You need only invest the portion of the sales proceeds that constitute capital gain. Any portion of the sales proceeds representing basis can be retained, invested or spent elsewhere. For example, if you sell an asset with an adjusted basis of $3M for $5M, you can invest the $2M gain into the QOF and qualify for the full benefits of the program. You are free to do whatever you would like with the remaining $3M.
5 A QOF funding and operating the project directly would be required to invest 90% of its assets in tangible property that satisfies the Original Use or Substantial Improvement requirements. However, if the QOF were to invest in a QOZ Business Entity, the QOZ Business entity would only need to be 70% invested in such tangible property.
6 There is another group of flying monkeys that is ready to attack your lease structure, but that's a topic for another day.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.