Opportunity Zones are now the hottest topic for impact investing, real estate and beyond, as they provide tax benefits to any U.S. taxpayer, of any type, and are projected to attract $100 Billion in investment, much of it to come in 2019 due to timing of tax incentives.
Congress enacted new tax incentives in the December 2017 Tax Cuts and Jobs Act intended to spur targeted economic growth by driving long-term capital to distressed communities in the U.S. and its territories. U.S. taxpayers now have an opportunity to defer and reduce the tax on capital gains so long as cash in the amount of such gains is invested as equity in a Qualified Opportunity Fund that is formed as a corporation or partnership for U.S. tax purposes (a "QOF
"), and the QOF in turn makes qualified equity investments in businesses and/or property in Qualified Opportunity Zones ("Opportunity Zones
- WHAT: Opportunity Zones are low-income areas nominated by the chief executive (e.g., governor) of a U.S. state or territory based upon the same definition of "low-income" as used for New Markets Tax Credit and later designated by the IRS.
- WHO: Any U.S. taxpayer can invest into a QOF the capital gains earned from the entity and elect the Opportunity Zone tax benefits.
- WHERE: What types of investments are made by QOFs in Opportunity Zones? The QOF must hold 90% of its assets in equity or property of a Qualified Opportunity Zone Business ("QOZB") within 6 months of forming the QOF, unless relief is available under the October Guidance or future regulations (the "90% Test"). A QOZB in turn must hold substantially all of its tangible property as "Qualified Opportunity Zone Business Property" ("QOZB Property").
- WHAT TAX BENEFITS: Three types of tax benefits are offered by the Opportunity Zone program: 1) deferral of tax on gain being contributed to a QOF, 2) increase in basis related to QOF interest, to exclude a portion of capital gain from deferred tax, and 3) further increase in basis related to QOF interest, to exclude gain on sale after 10 years.
The rules relating to Opportunity Zones are currently set forth in the Internal Revenue Code 1400Z, the proposed regulations issued on October 19, 2018 (the "October Proposed Regs
"), and Revenue Ruling 2018-29 (together with the October Proposed Regs, the "October Guidance
- What are "Opportunity Zones" and how are they designated?
Opportunity Zones are low-income areas nominated by the chief executive (e.g., governor) of a U.S. state or territory based upon the same definition of "low-income" as used for New Markets Tax Credit and later designated by the IRS. The final list of census tracts designated as Opportunity Zones was released by the IRS as of June 14, 2018 and includes approximately 8,700 census tracts spread throughout all 50 states and 5 territories. These comprise approximately 12% of the U.S. land mass, all of Puerto Rico and at least one Opportunity Zone in each major city. Designation details and updated information is available through the CDFI Fund.
- Who can invest in QOFs and when, in order to benefit from Opportunity Zone tax benefits?
Virtually any type of U.S. taxpayer (individuals, C Corporations, RICs, REITS and trusts, etc.), U.S. or foreign domiciled, can make an investment in a QOF. A specific rule also allows pass-through entities (such as a partnership or S-corporation), despite not being a U.S. taxpayer, to make a QOF investment and elect the Opportunity Zone tax benefits, or, if the entity does not elect the tax benefits, any individual investor in the entity can invest into a QOF the capital gains earned from the entity and elect the Opportunity Zone tax benefits. Nonresident U.S. taxpayers may also invest in a QOF in order to benefit with respect to certain FIRPTA gains.
Generally, a taxpayer must invest via equity in a QOF and transfer to the QOF cash equal to all or part of the capital gain within 180 days of the gain being recognized for U.S. tax purposes (e.g., upon a sale or exchange of property). In the case of an electing partner in a partnership, the investment in the QOF must occur within 180 days of the end of the tax year of the partnership that realized the capital gain. Capital gains from virtually all types of assets are eligible, other than from certain straddle transactions, "Section 1256 transactions, and related party transactions.
- What types of investments are made by QOFs in Opportunity Zones?
The QOF must hold 90% of its assets in equity or property of a Qualified Opportunity Zone Business ("QOZB") within 6 months of forming the QOF, unless relief is available under the October Guidance or future regulations (the "90% Test"). A QOZB in turn must hold substantially all of its tangible property as "Qualified Opportunity Zone Business Property" ("QOZB Property").
QOZB Property is tangible property used in a trade or business, where the property:
- is purchased after 12/31/17 from an unrelated party (20% cross-ownership rule determines who is a related party)
- the original use of such property commences with the QOF or the QOF substantially improves the property, and
- during substantially all of the QOF's holding period of the property, substantially all of its use is in an Opportunity Zone
The October Guidance addresses a number of definitional issues for these rules, including what it means for the QOF to "substantially improve" the property – to do so, a QOF must double up on the acquisition cost of the property, by making additions to the basis for the tangible property (i.e., per the October Guidance, to the buildings, not necessarily the land) during the 30-month period following the date of acquisition that exceed the QOF's adjusted basis in such tangible property.
Unless subsequent regulations provide greater flexibility for operating businesses held directly by a QOF in an Operating Zone, early QOFs will most likely be set up to own an interest through a separately created "second-tier" partnership or corporation, rather than directly operating the QOZB. This is due to at least two aspects of the October Guidance:
- Partial relief from the requirement that the QOF meet the 90% Test within 6 months – the October Guidance provides substantial relief and guidance by permitting assets to be deployed (in certain cases to acquire or construct qualifying assets), within a period as long as 31 months if deployed by the QOF, pursuant to a written plan, through a “second-tier” partnership or corporation. Similar guidance has not yet been provided for QOFs investing directly in QOZB.
- Offering of greater flexibility to QOF’s investing through “second-tier” partnerships or corporations – the October Guidance defines the holding of “substantially all” of the property of a “second-tier” partnership or corporation of QOZB Property to mean 70%. This translates into meaning that at least 90% of the QOF assets may be held in a “second-tier” partnership or corporation which, in turn, must invest 70% of its assets in QOZB Property – resulting in the possibility of just 63% being invested in the Opportunity Zone. Similar guidance has not yet been provided for QOFs investing directly in a QOZB, so a QOF that directly controls an QOZB must currently meet the 90% Test without further relief.
- What three types of tax benefits are offered by the Opportunity Zone program?
A brief illustration of the three tax benefits
- Tax Benefit #1: Deferral of Tax on Gain Being Contributed to a QOF
An investor who (i) sells or transfers property (including securities, tangible assets, real property, art, crypto assets) and recognizes capital gain (long-term or short) on the sale/transfer, and (ii) invests the amount of the gain in a QOF during the 180-day period following the date gain was recognized on the sale/transfer, may elect to defer the tax on the gain until the earlier of the date the investor's QOF interest is sold or December 31, 2026. The taxable amount recognized at the end of this period is the lesser of the amount of gain deferred and the fair market value of the QOF, thereby giving a taxpayer some relief if the QOF interest has declined in value. QOFs and/or their QOF investors need to plan for cash demands when the deferred tax comes due.
- Tax Benefit #2: Increase in Basis related to QOF Interest, to exclude a portion of Capital Gain from Deferred Tax
If a QOF investor holds its interest in a QOF for a period of 5 years of more, the QOF investor can exclude a percentage of the deferred capital gain from tax by increasing the investor's tax basis in its QOF interest. If the holding period is at least 5 years, investor's increase in basis will be 10% of the deferred capital gain; if the holding period is at least 7 years, investor's increase in basis will be 15% (i.e., an additional 5%), for an overall 15% tax exemption.
- Tax Benefit #3: Further Increase in Basis related to QOF Interest, to exclude gain on sale after 10 Years
If a QOF investor holds its interest in the QOF for 10 years or more, the QOF investor can elect to be forgiven tax at the time of sale or transfer of its QOF interest on all gains on appreciation of its QOF interest attributable to the originally deferred gain, by electing to increase its basis in the QOF interest up to an amount equal to its fair market value on the date of sale/transfer. If the QOF investor had invested additional amounts that were not a deferral of gains, those additional amounts would be viewed as a separate investment that is not eligible for this relief. Under the October Guidance, a taxpayer can elect to receive this tax benefit until December 31, 2047, well beyond the current expiration date for the designated Opportunity Zones of December 31, 2028.
- Investor sells real estate and realizes capital gain of $10M on January 1, 2019 (“CG Event”).
- On March 1, 2019 (i.e., within 180 days), Investor invests $10M in a QOF focused on affordable housing and has a tax basis of zero ($0) in the QOF
- On May 1, 2019, QOF acquires land and buildings and improves them for total cost of $9M
- On April 15, 2020 (TAX DAY FOR FYE 2019), Investor elects to defer gain from CG Event in respect of its QOF investment (no tax event due to Tax Benefit #1)).
- On December 31, 2026, Investor continues to hold QOF interest but its Tax Benefit #1 deferral ends
- On April 15, 2027 (TAX DAY FOR FYE 2026), Investor must pay tax for the 2026 tax year, including tax on the capital gains from the CG Event. However, since it had held its QOF interest for more than 7 years as of December 31, 2026, it can elect under Tax Benefit #2 to increase its basis in the QOF to $1,500,000 (i.e., 15% of the $10M capital gain), and pay tax only on $8.5M of gain (i.e., assuming the gain deferred is less than the current FMV of the QOF investment, the taxable amount recognized would be the $10M gain deferred less the $1.5M taxpayer’s basis in the QOF, or $8.5M),
- On July 1, 2029, the QOF Investor sells its QOF interest (i.e., after 10 years) and realizes a capital gain of $8M
- On April 15, 2030 (TAX DAY FOR FYE 2029): Investor elects to increase its tax basis in the QOF interest to match the FMV (sales price) and recognizes no gain due to Tax Benefit #3.
In this example, the fair market value of investor's interest in the QOF appreciated over the 10-year holding period, and it could expect to benefit from an increase in net returns on the QOF investment relating to the tax benefits alone, equivalent to the amount of tax saved through Tax Benefits #2 and #3. In the event that the investment lost money, the tax benefits would be limited to the initial deferral under Tax Benefit #1 and perhaps some relief from the gain (if the current FMV at December 31, 2026 were less than the gain deferred), but small consolation for a poor investment.
Orrick represents clients in the process of forming QOFs to utilize the tax incentives offered for investment in Opportunity Zones, and welcomes the opportunity to discuss investments or projects that might effectively use the new rules to benefit investors as well as communities throughout the U.S. and its territories.
For further information regarding Opportunity Zones and investment in Qualified Opportunity Funds, please click here
- What is the potential impact of Opportunity Zones on philanthropic donations, governmental support and donor advised funds?
While the provisions may have no direct impact on donor-advised funds and philanthropic grants, the Opportunity Zone program may increase the need for philanthropic capital and state and local government support - as private capital flows through QOFs to a wider range of projects in areas that are of the type that currently attract philanthropic capital and governmental financial assistance (typically in the form of grants or low-interest loans serving as program related investments (PRIs)), there is likely to be a demand for such support for the wider range of new projects.
Also, click here to view materials from the presentation A Deep Dive into Opportunity Zones: New Tax Incentives Stimulating Community Investment (including Proposed Regulations), co-Hosted by Impact Capital Forum & Orrick, Herrington & Sutcliffe LLP.