The U.S. Department of Treasury (“Treasury”) is expected to issue regulations providing administrative rules and guidance to clarify the operation and application of the Opportunity Zone program (the “OZP”); such regulations are currently under review by the Office of Management and Budget as of the date hereof. This long-awaited Treasury guidance is expected as early as the end of October 2018.
In December 2017, Congress passed the Tax Cuts and Jobs Act, which amended the Internal Revenue Code (the “Code”) to add a powerful new tax incentive, the OZP, which encourages long-term investments in low-income urban and rural communities designated by each state’s respective governor.
Those particularly interested in the OZP may include the following.
I. Introduction to the Opportunity Zone Program
New Code Sections 1400Z-1 and 1400Z-2 allow individual, corporate, or trust taxpayers, whether foreign or domestic, to defer an unlimited amount of capital gain from the sale or exchange of any property to an unrelated person by investing part or all of the proceeds in an Opportunity Fund within 180 days after such sale or exchange. The property sold can be stock, business assets, or any other property (whether or not the asset sold was located in, or connected in any way with, a qualified census tract). Only capital gains realized in sales or exchanges on or before December 31, 2026 can be deferred under the OZP.
A taxpayer makes such election to defer the gain, in whole or in part, when filing the taxpayer’s federal income tax return for the tax year that tax on gain from the sale or exchange would otherwise be due (note that the return must be filed timely, taking extensions into account).
For purposes of such investment, a “qualified opportunity fund” (“Opportunity Fund”) is any corporation or partnership (i) organized for the purpose of investing in Opportunity Zone Businesses, either directly or through qualifying corporations or partnerships, and that (ii) invests at least 90% of its assets in Opportunity Zone Businesses.
A “qualified opportunity zone business” (“Opportunity Zone Business”) is a trade or business (i) in which substantially all of the tangible assets owned or leased by the business is used in an Opportunity Zone, (ii) derives at least 50% of its gross income from the active conduct of a business in the Opportunity Zone, and (iii) has less than 5% of its assets invested in nonqualified financial property (which includes, for example, debt, stock, bank accounts, cash, partnership interests, etc.) However, Opportunity Zone Businesses do not include businesses engaged in owning or operating 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 the premises.
A qualified opportunity zone (“Opportunity Zone”) is any population census tract that is a low-income community (qualified census tract) that has been nominated, certified, and designated as an Opportunity Zone. A “qualified census tract” for this purpose is any census tract that has a poverty rate of at least 20% or that has a median income that does not exceed 80% of the higher of the median family income of the metropolitan area or the statewide median family income. The designation as an Opportunity Zone is effective until December 31, 2028. Please contact us if you would like additional information regarding qualified Opportunity Zones in any particular area.
To become an Opportunity Fund, an eligible taxpayer self-certifies, no approval or action by the Internal Revenue Service is needed. To self-certify, a taxpayer merely completes a form (which was expected to be released in the summer of 2018) and attaches that form to the taxpayer’s federal income tax return for the taxable year of certification (note that the return must be filed timely, taking extensions into account).
A taxpayer may elect to defer all or only a portion of the gain from a particular sale or exchange. For example, if an individual sells stock with a tax basis of $2 million for $10 million, the entire capital gain of $8 million could be deferred if at least $8 million of proceeds were timely invested in an Opportunity Fund. If the taxpayer instead invested only $5 million of the proceeds in an Opportunity Fund, then that amount of gain (i.e. $5 million) could be deferred and the other $3 million of gain would be taxable in the year of sale. If the taxpayer invested the entire $10 million of proceeds in an Opportunity Fund, the investment would be treated as two investments of $8 million and $2 million, with only the first investment (i.e. $8 million) eligible for the OZP.
It is unclear but presumably the beneficiaries of an Opportunity Fund investor that dies before December 31, 2026 could have all gains (i.e. deferred gain and gain resulting from future appreciation occurring prior to the date of death) forgiven as a result of the step-up in tax basis to fair market value as of the date of death. This would be a very strong incentive for elderly taxpayers to invest in an Opportunity Fund.
Administrative rules and guidance continue to be requested from Treasury by various coalition groups, including organizations exempt from tax under Code Section 501(c)(6); please contact us if you would like additional information regarding such an organization and its activities.
II. Analysis: Capital Gain Deferral under the Opportunity Zone Program
The deferred gains are taxable when the investment in the Opportunity Fund is sold or, if earlier, on December 31, 2026 (also known as “phantom income”, because all deferred gains must be included in income on December 31, 2026, whether or not the investment in the Opportunity Fund has been sold). Depending on the length of time that investors remain invested in their Opportunity Fund, they receive a 10% or 15% discount on their original capital gains tax bill, and the more patient investors will pay no capital gains taxes for any appreciation on their Opportunity Fund investment.
The amount of the deferred gain subject to tax is generally the entire amount of such gain (except that if the Opportunity Fund is sold at a loss, in which case only the actual gain realized is taxable). In the case of a gain, the amount subject to tax is: (i) the lesser of the amount of the deferred gain or the fair market value of the taxpayer’s investment in the Opportunity Fund on the date of gain recognition, minus (ii) the taxpayer’s basis in the Opportunity Fund. For this purpose the taxpayer’s basis in the Opportunity Fund is deemed to be zero, except as adjusted as discussed herein.
The gain would presumably be taxed in the same manner as it would have been taxed in the year of the sale or exchange (e.g. as capital gain from the sale of a business asset, capital gain that constitutes “net investment income” pursuant to Code Section 1411, “unrecaptured Code Section 1250 gain,” etc.) The deferred gain would be taxed at the rate in effect for the year of gain recognition (i.e. either the year the taxpayer’s interest in the Opportunity Fund is sold, or 2026).
The taxpayer’s basis in the Opportunity Fund is increased by the amount of deferred gain included in income, such that if the gain is recognized in 2026 but the taxpayer continues to hold the property past 2026, such gain will not be taxed again when the taxpayer sells its interest in the Opportunity Fund.
A. Tax Incentives of Opportunity Fund Investment Held for Five or Seven Years
If a taxpayer holds an investment in an Opportunity Fund for at least five (5) years, the taxpayer’s basis in the Opportunity Fund is increased (over zero) by 10% of the amount of the deferred gain, so that on sale of the Opportunity Fund investment, 10% of the deferred gain is permanently forgiven. A similar provision increases the basis by an additional 5% for an Opportunity Fund investment held for at least seven (7) years.
The anticipated Treasury guidance needs to address whether an investor would receive the benefit of these provisions if the five- or seven-year holding period straddles December 31, 2026. Because all of the deferred gain would be taxable on that date, the 10% or 15% basis increase could not offset deferred gain. However, it appears that it would nonetheless step-up the basis in the Opportunity Fund, and thus could offset gain from appreciation (if any) on sale of the Opportunity Fund interest. As noted above, the beneficiaries of an Opportunity Fund investor that dies before December 31, 2026 may be able to have all gains (i.e. deferred gain and gain resulting from future appreciation occurring prior to the date of death) forgiven as a result of the step-up in tax basis to fair market value as of the date of death.
For example, if on July 1, 2018, a taxpayer sold stock having a tax basis of $2 million for $10 million, timely invested the $8 million of proceeds in an Opportunity Fund, and then sold his Opportunity Fund investment on August 15, 2023, then only $7.2 million (i.e. $8 million, minus $800,000 (10% of $8 million)) of the $8 million of deferred gain would be subject to tax. If the sale of the Opportunity Fund investment were instead on August 15, 2025, only $6.8 million (i.e. $8 million, minus $1.2 million (15% of $8 million)) of the $8 million of deferred gain would be subject to tax. However, if the stock were sold and the Opportunity Fund investment were made on July 1, 2022, neither the 5-year nor the 7-year holding period would be met by December 31, 2026, and so the taxpayer would have to include the entire $8 million of gain in income for the 2026 taxable year. The taxpayer’s basis in the Opportunity Fund would be increased from zero to $8 million. If the taxpayer continued to hold the investment until August 15, 2027, and then sold such interest for $10 million, it appears that his or her basis would be further increased by $800,000 (10% of the original deferred gain), and thus the gain on the sale would be $2.2 million ($10 million, minus $8.8 million).
B. Tax Incentives of Opportunity Fund Investment Held for 10 Years
Another potentially valuable provision for an investor is contained in Code Section 1400Z-2(c). A taxpayer must elect for this provision to apply, in addition to the initial elections to defer gains. This provision provides that the basis in an Opportunity Fund investment held for at least 10 years is the fair market value of the investment on the date on which such investment is sold. Because the 10-year period will necessarily straddle December 31, 2026 (when the deferred gain is required to be taken into income), it appears that the potential effect of this provision is to forgive gain on appreciation of the Opportunity Fund interest. Therefore, a taxpayer may consider retaining his or her investment in the Opportunity Fund beyond December 31, 2026 and paying a tax on the phantom income triggered on such date, if he or she expected significant appreciation in the Opportunity Fund interest.
Continuing the above example, if a taxpayer sold stock, subsequently made an Opportunity Fund investment on July 1, 2018, then sold such investment on August 15, 2028 for $10 million, the tax basis would be stepped up from $8 million to $10 million, and such taxpayer would recognize no gain on the sale. It is not clear how the provision would be applied if the 10-year period extended beyond December 31, 2028, when designations of Opportunity Zones expire. The taxpayer previously included $6.8 million in income on December 31, 2026 (because the 7-year holding period was met as of that time), so the effect of the 10-year provision is to entirely exclude tax on appreciation.
If the December 31, 2026 “phantom income” date were extended by Congress, it is possible that an Opportunity Fund investor that holds its interest for at least 10 years could have all gains (i.e. deferred gain and gain resulting from future appreciation) forgiven, which would be a very strong incentive for taxpayers to invest in an Opportunity Fund.
III. Comparison: Gain Deferral under Code Section 1031 (Like Kind Exchange) to Gain Deferral under Opportunity Zone Program
For purposes of this illustration, assume that an individual taxpayer sells land with a tax basis of $2 million for $10 million.
In a Code Section 1031 exchange, the entire $10 million of proceeds from the sale must be invested in replacement property; any lesser investment would trigger capital gain. The taxpayer’s tax basis in the old replaced property (i.e. $2 million) becomes his tax basis in the new replacement property. If the taxpayer invested only $8 million of the proceeds in replacement property, then the taxpayer would have replacement property with $6 million of deferred gain and $2 million of gain taxable in the year of sale, with the taxpayer receiving net cash from the sale in an amount equal to approximately $1.5 million after taxes.
On the other hand, the OZP allows a taxpayer to invest all or only a portion of the gain or proceeds from the sale in an Opportunity Fund. If the taxpayer invested only $8 million of the proceeds in an Opportunity Fund, the entire capital gain of $8 million could be deferred (as adjusted for any step-up in tax basis should the taxpayer hold the Opportunity Fund interest for more than the five-, seven-, or ten-year holding period), with the taxpayer receiving net cash from the sale in an amount equal to $2 million (i.e. an amount equal to the tax-free return of basis in the sold property).
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.