Investment in a Qualified Opportunity Zone is a new program intended to connect private investment capital to low-income communities nationwide. This concept was originally presented in a bipartisan bill, the “Investing in Opportunity Act” as an innovative approach to spur long-term private sector investments in low-income urban and rural communities. While the stand-alone act did not progress through Congress, the provisions it contained were incorporated into the Tax Cuts and Jobs Act enacted on December 22, 2017.
According to The Economic Innovation Group, more than half of America’s most economically distressed communities contained both fewer jobs and businesses in 2015 than they did in 2000, and new business formation is near a record low. The average distressed community saw a 6% decline in local businesses during the prime years of the national economic recovery.
U.S. investors currently hold $2.3 trillion in unrealized capital gains, representing a huge untapped resource for economic development. OZ’s will incentivize investors to use some of this capital in exchange for significant tax benefits.
Taxpayers investing capital gains from the sale or exchange of property in a Qualified Opportunity Fund may take advantage of three significant opportunities:
Alone or in combination, these three provisions significantly enhance a taxpayer’s return on investment.
Qualified Opportunity Fund – An investment vehicle organized as a corporation or partnership for the purpose of investing in OZ property. Opportunity Funds are private sector entities required to invest 90 percent or more of their resources in OZ’s.
Qualified Opportunity Zone: A low-income census tract (LIC) designated by the governor of the state or territory in which it is located, and approved by U.S. Treasury.
Qualified Opportunity Zone Property – property which is:
While the deferral provisions operate similar to an IRC section 1031 like-kind exchange, the OZ concept is actually better, as it requires reinvestment of a recognized gain. A 1031 exchange requires reinvestment of all net proceeds from a sale. The deferral period ends the earlier of when taxpayer sells its investment in the Qualified Opportunity Fund, or December 31, 2026, at which time the taxpayer must include the amount of the gain in its gross income.
The amount of the gain is determined by subtracting the lesser of the amount of excluded gain or the fair market value from the amount of the taxpayer’s basis in the investment. The taxpayer’s basis in the investment is determined based on how long the taxpayer holds the investment. The taxpayer’s basis in the investment is initially deemed to be zero, but increases as the holding period of the investment reaches certain milestone periods:
An individual investor sells 1000 shares of Google stock (purchased in 2005 for $291,000). The sale results in a capital gain of $813,000. The individual would generally owe federal capital gains tax of $193,494 (23.8%) on this sale. If the investor instead rolls his $813,000 gain into a Qualified Opportunity Fund within 180 days of the sale, recognition of the $813,000 gain is deferred until the earlier of the date that the Opportunity Fund investment is sold or exchanged, or December 31, 2026.
If the investor holds the Opportunity Fund investment for at least five years, the basis in the original investment is increased by 10% of the deferred gain. $813,000 gain multiplied by 10% = $81,300 added to basis. A sale after five years will reduce the original deferred capital gain of $813,000 to $731,700.
If the investor holds the Opportunity Fund investment for another two years (total of seven years), the basis in the original investment is increased by an additional 5%. So, a sale after seven years will reduce the original deferred capital gain of $813,000 by a total of 15% to $691,050.
If the investor holds the Opportunity Fund for a total of 10 years, all appreciation on the investment in the Fund will be excluded from tax entirely. Assume that the value of the original $813,000 has now appreciated inside the Fund to $1,125,000 at the 10-year mark. The recognized gain of $312,000 will be exempt from any capital gains tax.
Note that the investor will have to pay the deferred capital gains tax as of December 31, 2026, even if the investment in the Fund continues. So, in this case, assuming the gain rollover took place before December 31, 2019, the investor would owe capital gains tax at a 23.8% rate on $691,050 at the end of 2026 and would have to use outside funds of $164,470 to cover this liability.
Governors of each state have until March 22, 2018 to submit their OZ designations to the U.S. Treasury Department for certification. Then, Treasury must act to publish regulations to guide the program, including rules for certifying Opportunity Funds and for ongoing compliance and reporting. Until that has happened, investors cannot take advantage of the OZ program.
It is important to note that the issuance of Treasury regulations often takes a long time. For example, when the New Markets Tax Credit program launched, it took more than two years for regulations to be issued. Given the specific gain recognition date of December 31, 2026 included in this legislation, we expect that community development entities will likely begin to solicit investors for OZ’s in advance of the issuance of regulations and final certifications, so that they can quickly move to invest once the rules are known.
Article written by:
Darci Congrove, CPA