Qualified Opportunity Zones: A New Tax-Advantaged Investment Strategy
The tax act (Pub. L. No. 115-97) introduced a new program designed to encourage investments in low-income communities throughout the country that have been designated as qualified opportunity zones (“Opportunity Zones”). Each state and U.S. territory was allowed to designate up to 25 percent of eligible low-income communities as Opportunity Zones. At this time, each state has submitted to the Treasury Department its list of proposed Opportunity Zones, and Treasury has approved designated Opportunity Zones across the nation. An interactive mapping tool that includes a data layer for all designated Opportunity Zones can be found by clicking here.Select the data layer tool on the right side of the map and select “Opportunity Zone Tract.”
The Opportunity Zone tax incentives include:
1. Harvesting current unrealized gains (whether short-term or long-term) on a tax-deferred basis until at most December 31, 2026;
2. Stepping-up the basis on deferred capital gains invested in a Qualified Opportunity Fund (“Fund”) if the Fund investment is held for at least five years (10 percent tax savings) or seven years (15 percent tax savings); and
3. Eliminating tax on gain from the sale of the Fund investment if held for at least 10 years.
There is an important time restriction that investors must be aware of prior to harvesting a capital gain intended for Fund investment. Taxpayers have 180 days from the triggering event to invest the deferred gain in a Fund. As a result, it is now too late to make a Fund investment with respect to capital gains triggered in January 2018.
A Fund is an investment vehicle (corporation or partnership) organized for the purpose of investing harvested gains. To qualify as a Fund, at least 90 percent of its assets must be invested in Qualified Opportunity Zone Property (“Zone Property”) (other than another Fund) acquired after December 31, 2017. Zone Property includes stock in a qualifying corporation, interests in a qualifying partnership or qualifying tangible business property.
The Internal Revenue Service (“IRS”) neither pre-approves nor certifies Funds. Instead, eligible taxpayers simply self-certify as a Fund by attaching a soon to be released form to their timely filed federal income tax return for the tax year.
For example, a bank, corporation or individual could harvest unrealized capital gains for the purpose of investing in a partnership that uses at least 90 percent of its assets to acquire Zone Property (e.g., real estate that will be substantially improved). If the investor holds the Fund investment for at least 10 years, the tax on the deferred capital gain will be reduced by 15 percent when it comes due on December 31, 2026. Moreover, no tax will be imposed on gain from the sale or exchange of the Fund investment.
Although the key government-related actions required to implement the Opportunity Zone program have been completed, and despite the seeming simplicity of the program, many unanswered questions remain. The IRS has said it will address many of these questions in promised regulations, but it is not clear when additional guidance will be forthcoming.
The remainder of this Alert discusses in greater detail key elements of the Opportunity Zone program and identifies some of the principal issues awaiting clarification from the IRS.
In contrast to federal programs that rely on tax credits to direct capital into financially distressed communities,e.g., low-income housing tax credits, rehabilitation tax credits,etc., the federal subsidy used to finance private investment in designated Opportunity Zones involves a current deferral of tax on the sale or exchange of property in combination with potential future tax savings. Specifically, new Section 1400Z-2 (“Section 1400Z-2”) of the Internal Revenue Code of 1986, as amended (“IRC”), generally provides that gain from the sale or exchange of any property can be deferred, and later reduced, if sale proceeds equal to the amount of the deferred gain are timely invested in a designated Opportunity Zone.
The Election to Defer Gain is Time-Sensitive
Section 1400Z-2(a)(1) provides that, at the election of the taxpayer, gross income for the taxable year will not include that portion of gain arising from the sale or exchange with an unrelated person of any property that is invested in a Fund during the 180-day period beginning on the date the property is sold or exchanged. It is important to recognize that the gain deferred under Section 1400Z-2 is merely pushed to a later year when it will be recognized for tax purposes. Whether a portion of the deferred gain is later excluded from tax depends on how the sale proceeds are invested and for how long the investment is held.
Section 1400Z-2 does not apply to a sale or exchange of property occurring after December 31, 2026, and the tax deferral period cannot extend beyond December 31, 2026. Also, the clock has already started to run for taxpayers who would like to roll-over the proceeds from a sale of property made earlier this year into a qualifying Fund. Whether those taxpayers can identify a Fund satisfying their risk profile and investment tolerances before expiration of the 180-day investment window is a key limitation on the usefulness of the new tax incentive. Although taxpayers could try to plan ahead by identifying appropriate Funds prior to entering into a sale of qualifying property, such advance planning is not always practical or available especially when financial markets are turbulent.
Deferral of Gain Rolled-Over Into a Fund
The gain deferred under Section 1400Z-2 is required to be included in the taxpayer’s income in the earlier of (i) the year in which the taxpayer sells the Fund investment, or (ii) December 31, 2026 (collectively, the “Trigger Year”).
The amount of the previously deferred gain taxable in the Trigger Year is based on the excess of:
- The lesser of the amount of the previously excluded (deferred) gain or the fair market value of the Fund investment as of the Trigger Date, over
- The taxpayer’s basis in the Fund investment.
It should be noted that the tax writers have not indicated how fair market value is to be determined in the context of a Fund investment that remains unliquidated on December 31, 2026. A method for determining fair market value in the foregoing context will hopefully be included in forthcoming regulations.
Section 1400Z-2(b)(2)(B) provides special rules for calculating the taxpayer’s basis in the Fund investment, which in turn determines the benefit, if any, associated with timely rolling over the deferred gain into a Fund (aside from the time value of money benefit associated with tax deferral):
- First, the taxpayer’s initial basis in a Fund investment is deemed to be zero;
- Next, the taxpayer’s basis in a Fund investment is increased for the amount of gain previously recognized on the sale or exchange of the original investment, if any;
- Next, if the taxpayer holds the Fund investment for at least five years, the basis of the Fund investment is increased by an amount equal to 10 percent of the previously excluded (deferred) gain;
- Next, if the taxpayer holds the Fund investment for at least seven years, the basis of the Fund investment is increased by an additional 5 percent of the previously excluded (deferred) gain (resulting in a cumulative basis increase of 15 percent); and
- Finally, if (i) the taxpayer holds the Fund investment for at least 10 years, and (ii) the taxpayer makes an additional special election, the basis of the Fund investment is increased so that it equals the fair market value of the Fund investment on the date that investment is sold or exchanged.
The above rules require taxpayers to separately calculate the tax on the deferred gain from the tax on the gain, if any, resulting from appreciation of the Fund investment. If an investor holds a Fund investment for at least 10 years, the investor must still pay tax in the Trigger Year on the previously deferred gain, albeit with a reduction in tax attributable to the basis step-up. On the other hand, the entire gain associated with the Fund investment will entirely avoid tax in the year that the investment is liquidated, even if that event occurs after December 31, 2026.
Because (i) the Trigger Year cannot occur subsequent to December 31, 2026, and (ii) the time frame of the Opportunity Zone program does not exceed 10 years, taxpayers must await guidance from the Internal Revenue Service regarding the time and manner for making the special election in the case of a 10-year Fund investment.
Also, because the cumulative 15 percent basis step-up for holding a Fund investment at least seven years is not subject to a special election, as in the case of a 10-year Fund investment, it does not appear that taxpayers who make a qualifying Fund investment after 2019 are eligible for the full 15 percent basis step-up (since the outside Trigger Date is December 31, 2026). Likewise, taxpayers who invest in a Fund after 2021 will not receive any step-up in basis. Of course, these consequences may be changed when the IRS eventually provides guidance.
Able owns 1,000 shares of Handbook stock with a basis of $10/share and a current market value of $50/share. Able sold all of his Handbook stock on March 1, 2018, which resulted in a realized gain of $40,000. Able has until August 28, 2018, (180 days after the sale date) to invest sale proceeds in a Fund equal to the amount of gain he elects to defer.
Assume Able elects to defer the full amount of his realized gain and invests $40,000 in a Fund on August 21, 2018. Further assume that Able sells his Fund investment on August 1, 2025, for $60,000. The amount of gain included in Able’s income for 2025 would be calculated as follows:
- The lesser of $40,000 (the amount of gain previously excluded) or $60,000 (the fair market value of the investment on the sale date);
- Less, Able’s basis in the Fund investment calculated as follows:
- Able’s basis in his Fund investment is initially set at $0;
- Able’s basis in his Fund investment is increased by the amount of the original gain previously recognized, which is $0;
- Able held the Fund investment for five years, thereby increasing his basis in the Fund investment by an amount equal to 10 percent of the deferred gain, which is $4,000 ($40,000 x 10 percent); and
- Able failed to hold the Fund investment for at least seven years, so he does not qualify for an additional 5 percent basis adjustment.
- The gain recognized by Able in 2025 associated with the prior deferral is $36,000 ($40,000 less $4,000). In that year, Able is also required to recognize a $20,000 gain associated with his sale of the Fund investment.
- Able’s total recognized gain in 2025 is $56,000. Without the benefit of the 10 percent basis step-up, Able’s total recognized gain in 2025 would have been $60,000, comprised in part by recognition of the prior unadjusted deferred gain ($40,000) and in part by the gain on his Fund investment ($20,000).
- If Able holds the Fund investment for at least 10 years, he would be allowed to exclude the full amount of gain associated with that investment. The 10-year holding period has no impact on the taxability of Able’s original deferred gain, which cannot be deferred beyond December 31, 2026.
The Definition of a Qualified Opportunity Fund
A Fund is generally an investment vehicle that is organized as a corporation or a partnership for the purpose of investing in Zone Property (other than another Fund) and holds at least 90 percent of its assets in Zone Property.
The IRS neither pre-approves nor certifies Funds. Instead, eligible taxpayers simply self-certify as a Fund by attaching a soon to be released form to their timely filed federal income tax return for the tax year.
Once a Fund is created, all that remains is for the Fund to acquire Zone Property using its seed capital. Zone Property is defined to mean property that is either (i) qualified opportunity stock, (ii) qualified opportunity zone partnership interest, or (iii) qualified opportunity zone business property.
A. Qualified Opportunity Zone Stock
Qualified Opportunity Zone Stock is defined as any stock in a domestic corporation if:
- The stock is acquired by the Fund after December 31, 2017, at its original issue (whether directly or through an underwriter) from the corporation solely in exchange for cash;
- At the time the stock is issued, the corporation is a Qualified Opportunity Zone Business (or organized for such a purpose); and
- During substantially all of the Fund’s holding period for the stock, the corporation retained its status as a Qualified Opportunity Zone Business.
B. Qualified Opportunity Zone Partnership Interest
Qualified Opportunity Zone Partnership Interest is defined as a capital or profits interest in a domestic partnership if:
- Such interest is acquired by the Fund after December 31, 2017, from the partnership solely in exchange for cash;
- At the time the interest is acquired, the partnership is a Qualified Opportunity Zone Business (or organized for such a purpose); and
- During substantially all of the Fund’s holding period for the interest, the partnership retained its status as a Qualified Opportunity Zone Business.
C. Qualified Opportunity Zone Business Property
Qualified Opportunity Zone Business Property means tangible property used in a trade or business of the Fund if:
- Such property was acquired by the Fund by purchase after December 31, 2017;
- The original use of such property in the Opportunity Zone commences with the Fund or the Fund substantially improves the property; and
- During substantially all of the Fund’s holding period for such property, substantially all of the use of such property was in a qualified zone.
Whether property meets the substantial improvement requirement depends on whether, during any 30-month period beginning after the date the property is acquired, additions to the property’s basis by the Fund exceed an amount equal to the adjusted basis of the property in the hands of the Fund at the start of the 30-month period.
D. Qualified Opportunity Zone Business
The term “Qualified Opportunity Zone Business” means either a domestic corporation or domestic partnership in which (i) 50 percent of the gross income arises from the active conduct of a trade or business in an Opportunity Zone, (ii) substantially all of the tangible property owned or leased by the Qualified Opportunity Zone Business is Qualified Opportunity Zone Business Property, (iii) a substantial portion of the intangible property is used in the active conduct of the Qualified Opportunity Zone Business’ trade or business, (iv) less than 5 percent of the aggregate unadjusted basis of the property of the Qualified Opportunity Zone Business is non-qualified financial property and (v) is not engaged in any of the following business activities: any 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 (the “Excluded Business Activities”).
Importantly, with the exception of the Excluded Business Activities, the term Qualified Opportunity Zone Business appears broad enough to encompass almost any state authorized business activity regardless of whether such activity is real-estate related or non-real-estate related.
Alternative to Like-Kind Exchanges Under IRC Section 1031
For some taxpayers, the investment of deferred gain proceeds in Opportunity Zones may serve as an alternative to a like-kind exchange under Section 1031 of the IRC. This is especially true in the case of a sale of property other than real estate, the gain on which is no longer eligible for deferral under IRC Section 1031.
In contrast to IRC Section 1031, which allows investors to defer gain on the sale or exchange of real estate for an unlimited period, Section 1400Z-2 only allows a gain to be deferred at most through December 31, 2026. On the other hand, whereas Section 1400Z-2 allows for a potential reduction of the amount of deferred gain subject to tax in the Trigger Year (e.g., the 10 percent and 5 percent basis step-up amounts), no similar tax benefit is provided in the context of a like-kind exchange under IRC Section 1031.
Although IRC Section 1031 is limited to gain deferral in the context of like-kind real estate, Section 1400Z-2 allows a time-limited deferral on gain arising from the sale or exchange “of any property,” regardless of whether such property is non-like-kind, tangible personal property or intangible property. The ability to defer gain arising from the sale or exchange of any property until at least December 31, 2026, is a powerful motivator for choosing a Section 1400Z-2 exchange over a Section 1031 like-kind exchange, assuming that an appropriate Fund investment can be identified within the 180-day selection period (which is identical to the time period over which replacement property must be acquired in the context of a forward like-kind exchange).
Application of Section 1400Z-2 to Real Estate Developers
A primary beneficiary of Section 1400Z-2 is a real estate developer that either self-funds a Qualified Opportunity Zone Business or self-certifies a Fund targeted at outside investors with the intent of using the capital raise in a Qualified Opportunity Zone Business. In many cases, a real estate developer will look to the same funding sources as it would have absent Section 1400Z-2, but capital raises may be somewhat easier given the financial incentive investors have to rollover deferred gain proceeds on a tax-advantaged basis.
Given the absence of regulations clarifying many of the unknown issues surrounding Section 1400Z-2, it does not appear likely that non-real estate specific markets will quickly develop. On the other hand, there would appear to be no reason why a real estate developer looking to invest in an Opportunity Zone would not pursue a self-certifying Fund as a means of attracting investment capital.
The economic and social benefits underlying the Opportunity Zone are unquestionably well-intentioned. Unfortunately, the speed with which Section 1400Z-2 was drafted has resulted in numerous open questions that has delayed Fund formation and given many investors reason to avoid liquidating current investments too quickly.
For instance, at this time it is unclear whether the tax writers intended to allow the tax-advantaged roll-over of proceeds only from sales or exchanges of property qualifying for capital gain treatment. The title to Section 1400Z-2 is “Special Rules For Capital Gains Invested In Opportunity Zones,” yet the first sentence of Section 1400Z-2(a)(1) refers to gain arising from the sale or exchange of “any property held by the taxpayer.”
Likewise, the definition of a Fund is limited to an investment vehicle organized as a corporation or partnership. It is not clear whether a Fund can be organized as a limited liability company classified as a corporation or partnership for federal tax purposes, although there would appear to be no valid reason why a limited liability company classified for tax purposes as a corporation or partnership could not be used as an investment vehicle for a Fund.
Another issue that has been raised by various commentators concerns rehabilitated or newly constructed property. Specifically, once an investment is made in an Opportunity Zone, it is not clear how the 30-month test for substantial improvement would apply to rehabilitated or newly constructed property.
While the investment community waits for the Internal Revenue Service to issue formal regulations providing guidance on these and other issues, taxpayers who have already liquidated investments in 2018 either are out of time to invest in a Fund or on the clock. Regardless of when the decision is made to dispose of qualifying property, investors must understand how an investment in an Opportunity Zone can (i) defer immediate gain recognition, (ii) potentially result in a partial exclusion of the deferred gain when the tax finally comes due, and (iii) potentially eliminate tax on gain from sale of the Fund investment. Given the ability to defer gain recognition on current property dispositions as long as December 31, 2026, the time value of money associated with the deferral period alone can provide a substantial financial benefit.