New Opportunity Zone ProgramOctober 31, 2018
The Internal Revenue Service (IRS) and Department of Treasury released proposed regulations under Internal Revenue Code Subchapter Z – Opportunity Zones, which was added by the 2017 tax reform legislation and enacted on December 22, 2017.
Through the Opportunity Zone program, investors are able to inject capital into low-income communities and promote long-term economic growth through a variety of investment vehicles. Investors also may receive significant tax benefits that include (1) tax deferral for capital gain invested in a qualified opportunity fund, (2) elimination of up to 15 percent of the tax on the capital gain that is invested in the qualified opportunity fund, and (3) potential elimination of tax when exiting a qualified opportunity fund investment. At the same time, municipalities gain access to private capital for the benefit of distressed communities.
Subchapter Z is intended to provide incentives for investments in qualified opportunity zones (QO Zones) by means of temporary capital gain deferrals and ultimately permanent exclusion from gross income of capital gains, if certain requirements are met. Under the new law, any gain from the sale or exchange of property by a taxpayer to an unrelated person, that is invested in a qualified opportunity fund (QO Fund), within 180 days of the sale of that property is excluded from gross income until the earlier of the date the investment in the QO Fund is sold or December 31, 2026.
The law requires only the gain to be reinvested into the QO Fund, not the total proceeds, which is different than other tax deferral tools such as like-kind exchanges. The gain deferred can be any gain (e.g., short-term, long-term, ordinary and Section 1231 gains) in connection with the disposition of property.
The taxpayer’s basis in the QO Fund is initially zero but will be increased by 10 percent of the deferred gain if investment is held for 5 years and increased by an additional 5 percent if the investment is held for 7 years. Therefore, if a gain on the sale of property is reinvested in a QO Fund within the required timeframe, taxpayers may be able to decrease the taxable portion of the originally deferred gain by 15 percent (an overall basis step up of 15 percent) if investment is held up to 7 years. For investments held for at least 10 years, the taxpayer will recognize no capital gain income on the appreciation of the asset from the time of the initial investment in the QO Zone through the sale of the investment. Where the taxpayer invests both capital gain proceeds and cash from other sources into a QO Fund, the Act specifically states that the investment will be treated as two separate investments of which only the capital gain proceeds will be eligible for the 10 year capital gain exclusion (and basis boosts).
Investors wishing to utilize the newly enacted opportunity zone program must invest their gain in a QO Fund. QO Funds can be structured as corporations or partnerships. In order to meet the criteria of a QO Fund, 90 percent of the assets held by the vehicle on the last day of the fund’s taxable year (and the last day of the first six-month period of the fund’s taxable year) must be qualified opportunity zone property (QOZ Property) within a QO Zone and the QO Fund must have acquired the property after December 31, 2017. The Act requires that the Treasury Secretary establish guidance for the certification process of QO Funds.
The governors must submit the notification of nomination to the Treasury Secretary by March 21, 2018, however, there is a 30-day extension period available for the March 21 deadline. The number of communities that can be designated as QO Zones in a state is limited to 25 percent of the number of low income communities in the state but if the state has less than 100, it is permitted to designate 25 tracts as QO Zones.