Opportunity Zones: In the Land of OZ, there is no place like home
Thirty-five million Americans live in over 8,700 Opportunity Zones across the country with almost 300 containing Native American lands.
Opportunity Zone legislation passed as part of the 2017 Tax Cuts and Jobs Act and there were immediate thoughts of the investment potential. While Opportunity Zones by themselves are not investments, they are an avenue from which investment opportunities are formed. Investment vehicles that invest in Opportunity Zones are Qualified Opportunity Funds (QOF). The Internal Revenue Code (IRC) defines “Qualified Opportunity Zones” as low-income census tracts nominated by state governors and certified by the U.S. Treasury as Qualified Opportunity Zones. The IRC also generally defines “low-income community” to be one in which the poverty rate for the census tract is at least 20 percent, or the median family income for the tract does not exceed 80 percent of the statewide median family income or, if applicable, 80 percent of the metropolitan area median family income, depending on certain other caveats defined in the IRC.
Opportunity Zone Benefits
Opportunity Zone legislation provides investors with three primary benefits: deferral of capital gains, reduction of capital gains, and exclusion of capital gains. According to the U.S. Treasury, there are over $5 trillion of unrealized capital gains in the United States. Investors subject to capital gains as a result of sales of assets can take advantage of the benefits provided by QOF investments as long as they do so within 180 days of the event that resulted in a capital gain. An investor may defer their capital gain tax liability until December 31, 2026, or the sale of the QOF, whichever comes first. An investor may also receive up to a 15% step-up in cost basis if the investment is made by December 31, 2019. The cost basis is stepped up by 10% after 5 years and an additional 5% after 7 years, giving a total of 15% reduction in capital gains tax. Lastly, if an investor holds the QOF for at least 10 years, there is no federal long-term capital gains tax due at sale. State tax treatment varies by individual state law.
Opportunity Zone Requirements
In order to assist investors in receiving preferential tax treatment, the QOF must be properly structured. QOFs must be structured as corporations or partnerships for federal tax purposes and investments by the QOF must be made substantially in Qualified Opportunity Zone Properties (QOZP) or Qualified Opportunity Zone Businesses (QOZB).
QOZP are tangible properties such as real estate, and a QOF investing in QOZP must meet a 90% test in which substantially all (at least 90%) of the fund’s assets must be in QOZP. This structure is known as a single-tier structure and the 90% test is the average percentage of assets calculated based on the two testing dates per year; generally, June 30 and December 31. Property is owned directly by the fund in a single-tier structure and the 90% test is quite rigid and difficult to comply with.
A two-tier structure, on the other hand, is one in which the QOF owns an interest in a partnership or corporation that qualifies as a QOZB. The interest itself qualifies as an asset for the purposes of the 90% test for the QOF, but “substantially all” for the purposes of the QOZB is 70%. That is, 70% of the QOZB’s property must be Qualified Opportunity Zone Business Property (QOZBP). In other words, 70% of the property owned by the QOZB is either original use property in the Opportunity Zone or property that has been substantially improved by the QOZB. The substantial improvement requirement simply means that the QOZB doubles its basis in the property within 30 months.
There are other caveats which include that 50% of the QOF’s gross income must come from activity in the Opportunity Zone, 40% of intangible property must be used in the activity of business in an Opportunity Zone, and the QOF may not invest in what are considered sin businesses such as golf courses, massage parlors, gaming facilities, country clubs and liquor stores.
Opportunity Zone Investment
Investing in Opportunity Zones is a long-term commitment (10 or more years) and the biggest benefits certainly fall to businesses and high net worth individuals with large short-term capital gains, but the investments are not only good for those looking for capital gains and tax benefits. There is social impact and growth potential in the investments. Municipalities have been heavily involved with Opportunity Zones in their areas and have been proactive in getting low-risk money into the Opportunity Zones. They have been involved in public-private partnerships and assisting with pre-development activities such as investments in roads and wastewater facilities that may be part of Opportunity Zone projects. Several municipalities have also created marketing campaigns enticing others to build or invest in their areas. Municipalities also have the ability to negotiate with private builders in a way they may offer financial incentives in exchange for percentages of the project, such as a certain number of units in a building, for example. Municipalities may also help speed along traditionally lengthy permit processes or help companies working with the Small Business Administration’s Opportunity Zone Program.
The thought is that investments in opportunity zones will have a direct effect on new jobs, an indirect effect bringing more business to business opportunities and an induced effect in allowing for more and new household spending in the area. Lastly, it is important to note that at least 50% of gross income of a Qualified Opportunity Zone Business must derive from active conduct of a trade or business in the Opportunity Zone. People appreciate parks and playgrounds, but even more they appreciate job opportunities.