B.A. Harris Blog

Opportunity Zone Investments

For decades, one of the most popular tools to defer taxes on capital gains has been the 1031 Exchange, offering almost unrivaled potential in the tax planning arena. However, the Tax Cuts and Jobs Act of 2017 has introduced The Opportunity Zones Program (OZP) which may benefit certain patient investors by providing an even more lucrative option than a 1031 exchange. The initiative offers taxpayers with large investment gains not only tax deferral, but tax savings of up to 15% of the original gain and even 100 percent of the gain from the subsequent disposition of your investment in the Qualified Opportunity Zone (QOZ). Unlike a 1031 Exchange, the OZP is not limited to real estate gains or exchanges, nor must the new investment be “Like-Kind” Additionally, the OZP offers the ability to keep some cash from the originating capital gain transaction (up to your basis in that capital gain asset) and you have 180 days to reinvest some or all of the remaining gain (without a qualified intermediary).

In an effort to address economic inequality, a bipartisan D.C. based think-tank known as the Economic Innovation Group (EIG), was tasked with encouraging investment of the U.S.’s current 6.1 trillion dollars in unrealized capital gains into some of the nation’s poorest areas. Their solution was The Opportunity Zones program (Code Section 1400Z-2) which offers substantial tax benefits for investors. Qualified Opportunity Zones (QOZ’s) are certain specified areas designated by the chief executives of every state and U.S. territory. There are currently over 9,000 OZ’s across the U.S and Puerto Rico, and a taxpayer may choose to invest in any one of them, regardless of their residence. In order to incentivize economic infusion within these underserved areas, the 4 tax benefit levels are as follows:

1)      DEFERRAL - If a capital gain is reinvested into a Qualified Opportunity Fund (QOF), those capital gains will be deferred and will not have to be recognized by the individual until the earlier of either:

  1. When the individual’s interest in the Opportunity Fund is sold, or
  2. December 31st 2026

2)      10% EXCLUSION - If the investment into the QOF is held for 5 years, 10% of the initial deferred capital gain invested into the fund is non-taxable.

3)      5% ADDITIONAL EXCLUSION - If the investment is held for 7 years, an additional 5% of the initial deferred capital gain is non-taxable.

4)      100% EXCLUSION - If the investment is held for 10 years or more (up until the year 2047), none of the appreciation above and beyond the originally deferred gain is recognized.  Again, capital gains earned from the date of the initial investment into the QOF will be non-taxable.

Obviously, the prospect of tax-deferred and tax-free capital gains is enticing, but it comes at a cost of a rather convoluted process which has had tax professionals pouring over the recently released regulations, with more clarifications to be issued in January, in order to better understand its mechanics. As of now, it appears that in order for an investment into a QOF to qualify for the tax deferral and gain exclusions promised by the program, there are several restrictions:

1)      The tax incentives are ONLY applicable to capital gains, both short and long term. Upon the eventual realization of your gains, they will retain their initial form of either short or long term.  Any funds invested in excess of the original capital gains are a separate investment and are not eligible for any of the benefits of this program.

2)      The sale which results in the capital gains must occur after December 22, 2017, and before January 1, 2027.

3)      The transaction which gave rise to the capital gains typically must be between unrelated parties.

4)      The capital gains must be reinvested into a QOF within 180 days of the initial sale.

With the above criteria met, the next step is to identify what exactly a Qualified Opportunity Fund is, and the requirements that an entity must meet in to carry on its status as a QOF.

1)      A QOF is either a partnership or corporation which must declare itself as a QOF by first filing form 8996

2)      These partnerships or corporations must be organized for the purpose of investing in a Qualified Opportunity Zone (QOZ)

3)      A QOF must operate within a Qualified Opportunity Zone (QOZ) and will be considered to do so if at least 90% of a QOF’s property is invested into Qualified Opportunity Zone Property (QOZP)

The 90% property test raises another concern as to what is considered to be Qualified Opportunity Zone Property, as it is clearly a crucial matter in maintaining a QOF’s preferred tax status. Examples of QOZP include:

1)      Tangible property used in a Qualified opportunity Zone Business (QOZB) purchased after December 31st, 2017 with its original use beginning with the QOF OR the QOF must substantially improve preexisting tangible property by at least the same amount of the purchase price.

  1. Example: A QOF may build a new apartment building OR it may purchase a pre-existing apartment building as long as the QOF renovates the property for at least the same amount that it was purchased for within 30 months of purchase.

2)      Qualified Opportunity Zone Business stock or partnership interest

Once again, a new term is introduced which could possibly muddy the waters for investors. As shown above, a QOF may meet the 90% property test through either direct purchase of QOZP, OR it may meet the 90% test by investing 90% of its funds into an existing QOZB. A Qualified Opportunity Zone Business meets the required standards by maintaining the following:

1)      At least 50% of the gross income must be from the active conduct of the trade or business

2)      At least 70% of its assets must be QOZP

3)      Less than 5% of the property of the business can be nonqualified financial property

4)      The QOZB may not be a

  1. Golf course                                                         e. Racetrack
  2. Country club                                                       f. Gambling establishment
  3. Massage parlor                                                 g. Bar/Liquor Store
  4. Hot tub/suntan facility

Although there are a multitude of hurdles to overcome in order to reap the tax benefits Qualified Opportunity Zones present, they ultimately boil down to any capital gains that reinvested into an Opportunity Fund that has the intent to serve a designated low-income area will receive tax deferral until the earlier of withdrawal from the fund or December 31st, 2026. Gains invested for at least 5 years will reach the first tax exclusion incentive and those held for at least 10 years receive multiple tax favorable benefits. With that in mind, to achieve the most benefit from an investment into an Opportunity Fund, keen investors are going to want to defer their gains as soon as possible in order to receive the greatest benefits.

Clearly this is a complicated process with even more detailed requirements and should only be undertaken under the guidance of a tax professional. If you are interested in learning more about what an investment into a Qualified Opportunity Zone could do for you, please contact us at B.A Harris LLP.

Aaron Lavarias

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