Opportunity Zones can provide big tax benefits
By Mike Crabtree, CPA, JD, tax partner, Boulay
Qualified Opportunity Zones are a creation of the new Code Sections 1400Z-1 and 1400Z-2, enacted in the Tax Cuts and Jobs Act (TCJA) in December 2017. These provisions are intended to incentivize investment in economically challenged areas by giving tax benefits to investors.
The tax benefits from Opportunity Zones come in two forms: A deferral of current capital gain, and the potential exclusion of future capital gain.
The current deferral comes when the investor makes an investment in a Qualified Opportunity Fund (defined later) within 180 days of triggering a capital gain. The gain can be long term or short term. The amount that can be invested is the gain amount, not the proceeds. For example, if an investor sells stock that has a $40,000 basis for $200,000, the amount of the investment in the Qualified Opportunity Fund that can get the favorable treatment is $160,000 -- the gain on the initial sale.
Gains that are invested in a Qualified Opportunity Fund are deferred until the earlier of i) the date the Qualified Opportunity Fund investment is sold, or ii) Dec. 31, 2026. The gain retains its character until it is realized, so if a short-term capital gain is deferred in a Qualified Opportunity Fund investment, it will be taxed as short-term capital gain when deferral is over, regardless of how long the Qualified Opportunity Fund investment is held.
If the Qualified Opportunity Fund investment is held at least five years, the basis of the investment (which is initially zero) is increased by 10 percent of the deferred gain amount. If the investment is held for seven years, the basis is increased by an additional 5 percent, for a total increase of 15 percent. This means that, assuming the investment is made before the end of 2019, and is held until after Dec. 31, 2026 (and does not decline in value), the amount realized at Dec. 31, 2016, will be 85 percent of the gain that is initially deferred. If the investment declines in value, the fair market value over the basis on the realization date becomes the amount realized.
Because the maximum basis adjustment benefit requires holding the investment for seven years, and the gain cannot be deferred beyond the end of 2026, the Qualified Opportunity Fund investment must be made by the end of 2019 to obtain the maximum benefit of the provision as it currently stands. Capital gains arising from sales after Dec. 31, 2026, cannot be deferred into Qualified Opportunity Fund investments.
The second tax benefit from a Qualified Opportunity Fund investment is the potential to exclude the gain on the appreciation of the investment. If the Qualified Opportunity Fund investment is held for at least 10 years, the investor can make an election to treat the tax basis of the investment as equal to its fair market value on the date of sale or exchange. This means that if the election is made, no gain or loss would be realized on the sale of a Qualified Opportunity Fund investment held for 10 years.
The initial deferred gain must be realized on Dec. 31, 2026, so the Qualified Opportunity Fund investment will have a tax basis equal to the gain realized at that time. If the value of the investment at the time of sale is below the amount realized at the end of 2026, the election to treat basis equal to fair market value would not be advantageous.
Qualified Opportunity Funds
A Qualified Opportunity Fund is an investment vehicle formed as either a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone Property, which includes Qualified Opportunity Zone Stock, Qualified Opportunity Zone Partnership Interests and Qualified Opportunity Zone Business Property. There are several rules and limitations that apply to these definitions.
The key requirement is that the Qualified Opportunity Zone Business must have 70 percent or more of its tangible property (owned or leased) meet the definition of Qualified Opportunity Zone Business Property. This basically requires that substantially all the use of the tangible property occur within a Qualified Opportunity Zone. The Qualified Opportunity Zones were determined by the chief executive officer of each state (the governor in Minnesota) from among the state's low-income communities. The Qualified Opportunity Zones have now all been certified by the Department of the Treasury.
Certain types of businesses are not eligible to be Qualified Opportunity Zone Businesses, including golf courses, country clubs, massage parlors, hot tub or suntan facilities, racetracks or other gambling facilities, or liquor stores.
Qualified Opportunity Funds must self-certify that 90 percent of their assets consist of Qualified Opportunity Zone Property. This is done annually on new Form 8996. If the Qualified Opportunity Fund fails to meet the 90 percent test for any month, it must pay a penalty unless it can show that the failure was due to reasonable cause.
One of the requirements of Qualified Opportunity Zone Business Property is that it is either new property or substantially improved by the Qualified Opportunity Fund. To meet the "substantially improved" threshold, the additions to basis over a 30-month period must exceed the Fund's initial basis at the beginning of the period. In other words, the improvements to the property must exceed the initial cost in most cases. For real estate projects, the underlying land is not considered in the improvement determination.
Tax benefits are not the only thing to consider when evaluating a potential Qualified Opportunity Zone investment. Qualified Opportunity Zone Businesses are likely to be small businesses, which inherently have more risk than many other investment alternatives. Because these businesses generally must be located in historically distressed areas, there may be additional challenges to overcome. All aspects of the investment must be analyzed to make sure it fits with the investor's risk tolerance.
Most of the tax benefits of the Qualified Opportunity Zone provisions come from holding the investment for a considerable amount of time, so the investments should therefore be considered illiquid. The lure of tax benefits will hopefully not entice too many taxpayers that don't have the appetite for such investments, but for the right investor and the right investment, these new provisions are a tremendous opportunity.
Mike Crabtree, CPA, JD is a tax partner at Boulay. He has more than 17 years of experience finding answers to tax questions for businesses and individual clients. You may reach him at firstname.lastname@example.org or 952-841-3032.