One of the little-known provisions of the Tax Cuts and Jobs Act signed into law on Dec. 22, 2017 is the introduction of Opportunity Zones. These zones are census tracts in economically distressed communities where new investments may be eligible for preferential tax treatment. The IRS recently certified Opportunity Zones for investment in all 50 states, in every major metropolitan area, to spur this economic activity, through the creation of Qualified Opportunity Funds (QOFs). QOFs are partnerships or corporations formed specifically to invest in Opportunity Zones.
There are numerous benefits to investing in an Opportunity Zone:
- Investors can defer tax on any prior gains until the earlier of the date on which an investment is sold or exchanged, or Dec. 31, 2026, as long as the gain is reinvested in a QOF within 180 days of the gain occurring.
- Capital gains on investments in QOFs held for five years are reduced by 10%; if held seven years, they are reduced 15%.
- If the investment in the QOF is held for at least 10 years, the investor is eligible for an increase in basis equal to the fair market value of the investment on the date it is sold or exchanged. Simply put, there would be no capital gains on qualified investments held for 10 years or longer.
The “prior gains” invested in QOFs can be any gains. For example, gains on stock sales within 180 days of the gain on that sale would qualify; investing that money in the QOF would allow for deferral.
Guidance Needed to Clarify Grey Areas Prior to Investment
Now that Opportunity Zones have been finalized and approved, the next step is for the Treasury Department to issue regulations. The most optimistic timing for issuance of guidance is likely toward the end of 2018. There are a number of technical matters that ideally should be resolved before one pursues a QOF structure. For example, if a QOF pursues a ground-up development, it is not clear whether the land cost would be a qualifying asset for purposes of the 90 Percent Test. (Under the 90 Percent Test, a QOF must hold at least 90 percent of its assets in a QOF property.)
A number of other unanswered questions present uncertainty for prospective QOF investors:
- How soon after a QOF receives an investment of cash must it be invested in qualifying Opportunity Zone property?
- As mentioned above, the enacted statute requires investors to recognize gain on all (or a portion if they hold their interest in the QOF for five or seven years) deferred gain no later than Dec. 31, 2026 and pay tax. If an investor holds an investment in a QOF for 10 years, they are eligible for a Fair Market Value Basis Election, which effectively enables them to permanently eliminate the gain on sale of the QOF. Does this mean an investor meeting the 10-year holding requirement must request a refund for tax paid after 2026?
- It appears that gain from the sale of qualified Opportunity Zone property cannot be further deferred under the Opportunity Zone program because QOFs must be organized for investing in qualified Opportunity Zone property, not interests in other QOFs. If a QOF sells assets, how long is a “reasonable period of time” within which cash proceeds must be reinvested in qualified Opportunity Zone property without jeopardizing the 90 Percent Test?
- One more technical area where guidance would be helpful is on the disposition of a qualifying business. As currently constructed, the statute allows the investor the benefit of the Fair Market Value Basis Election if they sell their interest in the fund. If the QOF sells the underlying assets before an investor sells its interest in the QOF, the Fair Market Value Basis Election is not available. Was this Congressional intent, and will investors receive favorable guidance permitting the election based on the fund’s sale of assets?
If the Treasury Department delays issuing definitive guidance, many investors may be reluctant to proceed with a QOF investment, not knowing if their investment will actually qualify. Clarity could come before year-end, but there is no assurance of this. Investors should consult with a qualified tax advisor and continue to watch for additional guidance on QOFs.
The U.S. Department of Treasury website includes an Opportunity Zone page that includes a listing of the various Opportunity Zones, as well as related FAQs.
The information in this blog is intended to provide a sense of the current environment and identify some of the key issues for consideration before proceeding with a QOF structure. If you have questions about Opportunity Zones, Qualified Opportunity Funds or other tax planning and preparation issues, please contact Josh Stein, CPA, at 330-668-1100 or email Josh.