The Tax Cuts and Jobs Act in 2017 established the newest tax deferral fund type. Opportunity Zone Funds have created new possibilities in the commercial real estate and venture capital industries. The goal of the law was to foster development and investment in economically distressed areas. State governors designated some 8,700 zones across the country. A Qualified Opportunity Fund (QOF) investor may be able to defer, reduce, or even eliminate some capital gains taxes depending on the circumstance. One aim of the law was to give a sense of urgency to likely investors to generate as much investment, as quickly as possible. Lawmakers overarching goal is to raise up the level of employment and economic activity in the zones. Advisors who may have a client looking to mitigate federal capital gains taxes, especially those who have a capital gain event in the upcoming year, can find value in understanding Opportunity Zones.
There are several important holding requirements that investors need to understand:
- Investors can defer tax on any prior gains invested in a QOF until the earlier of the date on which the QOF is sold or exchanged, or the “Trigger Date” of December 31, 2026.
- If the QOF investment is held for longer than five years, there is a 10% exclusion of any deferred capital gain.
- If it is held for more than seven years, the exclusion becomes 15%.
- If the investment in the QOF is held for more than ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged. This is the real zinger.
- In sum, the whole structure is tiered to favor long-term investment in the QOF zones. The benefit of holding for ten years rather than seven is potentially great, other things being equal (assuming appreciation of the property or business in the QOZ).
The IRS still needs to clarify certain rules concerning Opportunity Zones, but the most recent guidelines have given investors a lot to work with. For an investor to take advantage of the full reduction benefit the investment must be made by December 31, 2019, so investors are flocking to QOFs quickly to get the maximum benefit. This is due to the December 31, 2026 “Trigger Date” and the seven-year hold requirement to get the 15% reduction.
As mentioned earlier, the tax deferral lasts until December 31, 2026, or when the OZ investment is disposed of (if earlier). The step-up in basis allows investors to exclude up to 15% of the original capital gain if the investment is held for more than seven years. Finally, the permanent exclusion of capital gains from the sale or exchange of the OZ investment is allowed if it is held for at least 10 years. This exclusion only applies to gains made after the investment in the QOF. QOFs allow for tax reduction on top of deferral. The tax benefits fall into several buckets:
- Potential capital gains rollover
- Partial exclusion of original capital gains, depending on holding period
- Step-up in the cost basis of the acquired property to current market value at the time of sale, depending on the holding period
- Tax-free growth of QOF investment due to the step-up in basis
The IRS, on April 17th of this year, clarified opportunity zone fund requirements. This is the second clarification that has come out this year. Some investors were originally skeptical about QOFs due to some of the opacity surrounding the requirements. Having these questions clarified likely will alleviate many investor concerns. One of the main requirements of the law is that qualified funds must have 90% of their assets invested in opportunity zones. Stakeholders requested that this requirement be clarified. The clarified rules state that funds do not have to consider assets that have been held for less than 6 months when calculating the 90% asset requirement. Additionally, a fund that sells an asset has twelve months to redeploy those proceeds. On top of that, funds have 6 months to deploy any new capital they receive.
Another aspect of QOFs is that they can invest in QOZ businesses and still earn the tax benefit. The goal of this aspect of the law was to encourage business development and employment in the OZs. Qualified businesses must earn at least half their gross income within an opportunity zone. The requirements on how to qualify as an OZ business were flagged early on as potentially problematic to prove. The new guidance from the IRS clarified three ways to prove that funds are conducting enough business within an OZ, as follows:
- If at least 50% of the hours the employees work is within the zone.
- If the company performs at least half of its services within the zone.
- If there are significant management or operational functions within the zone.
The new guidelines and guidance will likely encourage more investment in opportunity zones. Staying informed and current is vital. Advisors need to understand the rules and guidelines to help their clients understand the opportunities in OZs. Sponsors need to understand the rules to ensure their QOF remains within the guidelines. Investors need to understand the potential benefits and requirements of OZs. Many people hope that the communities in Opportunity Zones will become more economically vibrant because of this new program. Concerned citizens should care about these communities wellbeing, and if positive changes occur, that will be a reason to celebrate.