What You Should Know About Qualified Opportunity Zones
The 2017 Tax Cuts and Jobs Act established the Qualified Opportunity Zone program to provide a tax incentive for private, long-term investment in economically distressed communities (Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code). Investors in these programs can defer and, potentially, reduce tax on short or long term capital gains (“Gains”) by investing in a Qualified Opportunity Zone Fund (an “OZ Fund”).
What is an OZ Fund?
An OZ Fund is a tax partnership or corporation (it is unclear whether this includes S corporations) that is organized for the purpose of investing in qualified opportunity zone property. An OZ Fund can be an existing entity, but pre-existing investments in it will not qualify for the tax benefits discussed below.
An entity will self-certify that it is an OZ Fund on Form 8996
(which, as of the date of this alert, is only a draft form). To be entitled to OZ Fund treatment, the entity must invest at least 90% of its assets in qualified opportunity zone property (“OZ Property”).
How does an OZ Fund invest in OZ Property?
Ninety percent of an OZ Fund’s assets are OZ Property if it either (i) directly conducts a qualified opportunity zone business (an “OZ Business”) by investing 90% of its assets in qualified opportunity zone business property (“OZ Business Property”); or (ii) acquires equity in a subsidiary that operates an OZ Business which invests substantially all of its assets in OZ Business Property.
What is OZ Business Property?
Property must meet certain requirements to be considered OZ Business Property:
What is a Qualified Opportunity Zone?
- It must be tangible property acquired after December 31, 2017.
- Substantially all of the property is used within an OZ.
- The original use of the property within the OZ begins with the business. The implication of this requirement is that purchased used property could qualify as OZ Business property, if it was only used previously outside of an OZ.
- The OZ Fund, or the OZ Business, “substantially improves the property.” The property is substantially improved if, within 30 months of buying it, the OZ Fund or the OZ Business spends more to improve the property than it did to buy it. In the case of a purchase of land that already has a building on it, it only has to make improvements at least equal to the amount of the purchase price allocated to the building.
- Substantially all of the property is used within an OZ.
Qualified Opportunity Zones (“OZs”) are specially designated (generally) low-income census tracts designated by state governors. A nationwide map of OZs is available here
. A Maryland-specific map of OZs is available here
So if a business holds OZ Business Property, it (or its parent corporation or partnership) can certify that it is an OZ Fund? Are there any other requirements for a business to be considered an OZ Business?
Yes, there are:
What are the benefits of investing in an OZ Fund?
- At least 50% of the gross income from the business must be from the active conduct of a trade or business.
- A “substantial portion” of intangible property must be used in the active conduct of a trade or business.
- Less than 5% of the property of the business can be nonqualified financial property.
- The business cannot be a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other gambling, or liquor store; usually referred to as a “sin business.”
There are three ways investment in an OZ Fund may provide a tax savings (1) tax deferral through 2026 on some or all of your Gains, (2) no tax on up to 15% of deferred Gains and (3) no tax on appreciation of OZ Fund property.
Tax Deferral on Gains
: The most immediate benefit of investing in an OZ Fund is that you may defer the tax on some or all of such Gain if, during the 180-day period beginning on the date of sale/exchange, you invest in an OZ Fund. Any such Gain is not recognized until the earlier of your sale or exchange of your interest in the OZ Fund or December 31, 2026.
Reduced Taxable Gain
: After five years of deferral via an investment in an OZ Fund, you will receive a 10% step-up in tax basis and, after seven years, an additional 5% step-up. To take full advantage of the 15% step-up, you must invest Gains in an OZ Fund by December 31, 2019.
Tax Free Appreciation
: If an investment is held for ten or more years in an OZ Fund, when you sell your investment in the OZ Fund, none of the appreciation above the Gain is recognized. Further, you must sell your interest in the OZ Fund before December 31, 2047, to take advantage of any tax free appreciation.
Within 180 days after generating Gains, those Gains should be invested in an OZ Fund. A partnership or C corporation can qualify as an OZ Fund by either directly investing in OZ Business Property or forming a subsidiary that owns OZ Business Property. OZ Business Property is property located within an OZ that is first used by the OZ Business or substantially improved by the OZ Business.
If the Gains are held in the OZ Fund for at least 5 years (and were invested before December 31, 2021), the recognized amount of Gain is reduced by 10%. If the Gains are held in the OZ Fund for at least 7 years (and were invested before December 31, 2021), the recognized amount of Gain is reduced by 15%.
On December 31, 2026, any deferred Gains are recognized, taking into account any 5 year or 7 year step-up. If the investment in the OZ Fund is sold after ten years, but before December 31, 2047, any appreciation in the value of the investment is not taxed.
On November 30, 2018, you sell a long term capital asset and generate $1 million of gain. You invest the $1 million of gain in an OZ Fund on January 31, 2019. Under the OZ statute, on January 31, 2019, the basis of your investment in the OZ Fund is $0. On January 31, 2024, assuming you have not sold the investment, your basis automatically increases to $100,000. On January 31, 2026, assuming you still have not sold the investment, your basis again increases to $150,000.
On December 31, 2026, you recognize the $850,000 of deferred long term capital gain, and your basis in the OZ Fund investment increases to $1 million.
On December 31, 2030, you sell your interest in the OZ Fund for $4 million (i.e., the fair market value of your investment appreciated by $3 million). Because you held your interest in the OZ Fund for more than 10 years, you elect to treat the basis in your investment as the FMV of the investment, or $4 million. Consequently, you do not recognize any gain on this sale. Stated another way, you realized a total of $4 million of gain, only $850,000 of which was subject to tax (at a long term capital gain rate). Assuming a 20% long term capital gain tax rate, the effective tax rate on your $4 million is gains was 4.25%.
For planning purposes, there are still some unanswered questions
- OZ Business Property includes leased property. It is unclear how a business leasing property within an OZ treats that property for purposes of satisfying the requirement that 90% of its assets be located in an OZ or the requirement to substantially improve such property.
- Whether there are transactions other than a sale that will trigger gain recognition.
- An OZ Fund may sell its investment in an OZ Business. Future guidance is expected to address the time period for an OZ Fund to reinvest in an OZ Business and not lose its status as an OZ Fund.
- What constitutes active conduct of a trade or business with respect to the use of intangible personal property as OZ Business Property.
This client alert only scratches the surface of the requirements of the Qualified Opportunity Zone program. If you are considering making an investment in an area designated as an OZ, you should speak with your attorney about whether or not this program offers additional benefits. You should also speak with us if you want to set up an OZ Fund, plan for gains to decide whether an OZ Fund or a 1031 exchange is more beneficial or are in an OZ Fund and need help planning to take advantage of the new law.