The Tax Cuts and Jobs Act created a section of the Tax Code that allows taxpayers to take advantage of a new investment vehicle called Opportunity Funds. The purpose of this new investment vehicle is to help direct resources to low-income communities, known as Qualified Opportunity Zones, through a more market-driven approach.
A temporary tax deferral for capital gains reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the date on which the Opportunity Zone investment is sold or December 31, 2026.
A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis of the original investment is increased by 10% if the investment in the qualified Opportunity Fund is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years, excluding up to 15% of the original gain from taxation.
A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified Opportunity Zone fund, if the investment is held for at least 10 years. (Note: this exclusion applies to the gains accrued from an investment in an Opportunity Fund, not the original gains).
Furthermore, there is no cap on the amount of money that can be invested in Qualified Opportunity Funds.
The investor must invest in a fund within 180 days after the sale or exchange of the capital asset. The fund can be a partnership, a corporation or a limited liability company. The investor receives either stock or an interest in the fund. The fund must invest in Qualified Opportunity Zone Property, explained below. The fund must hold at least 90 percent of its assets in Qualified Opportunity Zone Property. The percentage of assets is measured “on the last day of the first 6-month period of the taxable year of the fund, and on the last day of the taxable year of the fund.” If a fund fails to meet the 90% standard, it is subject to a penalty for each month it fails to meet the required threshold. The penalty is “(i) the amount equal to 90 percent of its aggregate assets, over (ii) the aggregate amount of qualified opportunity zone property held by the fund, multiplied by the underpayment rate established under [Code] section 6621(a)(2)” for each month the Fund fails to meet the required threshold. IRC § 1400Z-2(f)(1).
In the summer of 2018, the IRS is issuing a form that will allow taxpayers to self-certify as a Qualified Opportunity Fund. After taxpayers complete the form, they must attach it to their timely filed income tax return for the tax year.
The fund must hold at least 90 percent of its assets in Qualified Opportunity Zone Property, which includes Qualified Opportunity Zone Stock, Qualified Opportunity Zone Partnership Interest, or Qualified Opportunity Zone Business Property. Each form of Opportunity Zone Property must meet the specifications set forth below.
Stock: Qualified Opportunity Zone Stock is any stock of a domestic corporation that was obtained by the fund after Dec. 31, 2017 from the corporation, either directly or through an underwriter, solely in exchange for cash. The corporation must be a Qualified Opportunity Zone Business, as defined below, when the stock is purchased. If the corporation is a new corporation then it must be organized for the purpose of being a Qualified Opportunity Zone Business. The corporation must qualify as a Qualified Opportunity Zone Business for a substantial duration of the Fund’s holding period.
Partnership interest: A Qualified Opportunity Zone Partnership Interest is any capital or profits interest in a domestic partnership that was acquired after Dec. 31, 2017 by the fund in exchange for cash. Similar to Qualified Opportunity Zone Stock of a corporation, the partnership must be a Qualified Opportunity Zone Business when the interest is purchased or, in the case of a new partnership, it must be organized for the purpose of being a Qualified Opportunity Zone Business. Lastly, the partnership must qualify as a Qualified Opportunity Zone Business for a substantial duration of the fund’s holding period.
A Qualified Opportunity Zone Business means a business that owns or leases substantially all of its tangible property in Qualified Opportunity Zone Business Property. The business must also generate at least 50 percent of its total gross income from active business conduct with “a substantial portion of the intangible property of such entity used in the active conduct of any such business,” and “less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity attributable to nonqualified financial property.” Lastly, the business cannot be a “private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.”
Business property: Qualified Opportunity Zone Business Property is tangible property acquired after Dec. 31, 2017 that is used in a Qualified Opportunity Zone trade or business and either the use of the property in the Qualified Opportunity Zone originates with the fund, or the fund substantially improves the property so long as “during substantially all of the Qualified Opportunity Fund’s holding period for such property, substantially all of the use of such property was in a Qualified Opportunity Zone.” Property is considered substantially improved if “during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.” For example, if the original use of the property does not begin with the fund and the fund acquired the property for $75,000, then it is required to invest an additional $75,000 into the property in order for it to qualify as Qualified Opportunity Zone Business Property. Note that there is no limitation preventing the Fund from borrowing cash in order to purchase or improve the property.
Real estate developers can establish a fund in order to generate third-party investment capital for their projects. Furthermore, they can use their fund to defer tax on the sale of capital assets. In addition, by investing the gain in a Qualified Opportunity Fund, they will be paying less in taxes. To illustrate this point, if an investor puts capital gains generated from the sale of a capital asset into a fund for eight years, with the basis increase and a 5 percent present value discount to value the deferral, investors will pay only 57 percent of what they otherwise would pay in taxes.
In the case of a passive investor, the investment into the fund allows deferral of tax payments on recognized gains for up to eight years (the latest date being Dec. 31, 2026) with an up to 15 percent gain reduction and the possibility of avoiding any income tax on the Qualified Opportunity Zone investment if held for at least 10 years.
Visit the U.S. Department of Treasury CDFI Fund website for the most up-to-date information and resources on Opportunity Zones. You will find IRS procedures, a list of designated Qualified Opportunity Zones in the United States, as well as an interactive map that will help you identify if a particular address is located in a qualified census tract.
Click here to view a list of Frequently Asked Questions about Opportunity Zones.