By Garth Stevens and Marc Schultz*
The Tax Cuts and Jobs Act passed in 2017 created as a new federal income tax incentive program, the opportunity zone program, located in Section 1400Z-1 and Section 1400Z-2 of the Internal Revenue Code of 1986. In just the past few weeks, the U.S. Department of the Treasury and the IRS issued much anticipated guidance on many important aspects of the opportunity zone program, which has now moved investors’ and other business stakeholders’ interest in opportunity funds into high gear.
The opportunity zone program is designed to encourage private capital investment in qualified “opportunity zones,” which are designated census tracts throughout the United States that qualify as low-income communities. Opportunity zones have now been designated in almost all states, including California. Various parts of Los Angeles, Orange and Riverside Counties and much of greater San Diego incorporate designated opportunity zones (among many other parts of the state).
What is an Opportunity Fund?
The opportunity zone program provides investors with significant tax benefits for investing in opportunity zones, provided that such investments are made through qualified opportunity funds, which serve as intermediaries between the investors and the particular opportunity zone investments.
An opportunity fund is an investment vehicle that has been organized as either a corporation or a partnership (typically formed as a limited partnership or a multi-member limited liability company), has undergone (or will timely undergo) the requisite certification process, and holds at least 90% of its assets in qualified “opportunity zone property” (as further discussed below). Certification is a self-certification process whereby the opportunity fund attaches IRS Form 8996 to its federal income tax return for the tax year in which the fund first elects to be an opportunity fund and to its federal income tax return for each subsequent tax year. An opportunity fund may be formed to invest in a single project, such as a real estate development or in a qualified entity. However, the opportunity fund may also be formed to invest in multiple different investments.
As noted above, an opportunity fund is required to hold at least 90% of its assets in “opportunity zone property” (described below). An opportunity fund holds opportunity zone property either by directly holding “opportunity zone business property” or by holding stock (treated as equity) or partnership interests in a domestic corporation or partnership, where such stock or partnership interest is issued to the opportunity fund after Dec. 31, 2017, in exchange for cash, as long as such entity is a qualified “opportunity zone business” (described below) on certain testing dates.
In general (and subject to certain other qualifications not mentioned here), an “opportunity zone business” is an entity engaged in a trade or business in which substantially all (at least 70%) of its tangible property owned or leased is opportunity zone business property, and where such entity derives at least 50% of its gross income from the active conduct of a trade or business in an opportunity zone. “Opportunity zone business property” is tangible property used in a trade or business of the opportunity zone business or opportunity fund (as the case may be) that was acquired by the opportunity zone business or opportunity fund (as the case may be) by purchase from an unrelated person after Dec. 31, 2017 and that meets other certain requirements.
Tax Benefits to Opportunity Fund Investors
The opportunity zone program provides three principal benefits to taxpayers who invest in opportunity funds. The first principal benefit is that a taxpayer (by making an election) may defer any taxable capital gain (short term or long term) arising from a prior sale transaction (e.g., a sale of a company or business, or a division thereof, real property or other assets), where the purchaser in such transaction was an unrelated person, by investing all or a portion of such taxable capital gain in an opportunity fund within 180 days after the date of the sale. The amount of the taxable capital gain that is deferred by the taxpayer is equal to the amount that the taxpayer invests in the opportunity fund.
The deferred gain (i.e., the amount the taxpayer invests in the opportunity fund) is required to be included in the taxpayer’s income for tax purposes upon the earlier of (a) the date that the taxpayer sells or exchanges his interest in the opportunity fund or on which the opportunity fund liquidates, or (b) Dec. 31, 2026. However, the second principal benefit of the opportunity zone program is that if the taxpayer holds his investment in the opportunity fund for at least five years prior to the date on which the taxpayer is required to include the deferred gain that the taxpayer invested in the opportunity fund in his income for tax purposes (as noted in the prior sentence), the amount of the deferred gain to be included in the taxpayer’s income will be effectively reduced by 10%; and if the taxpayer holds his investment in the opportunity fund for at least seven years prior to the date on which the taxpayer is required to include the deferred gain that the taxpayer invested in the opportunity fund in his income for tax purposes, the amount of the deferred gain to be included in the taxpayer’s income will be effectively reduced by an additional 5%.
In short, not only can an opportunity fund investor defer paying federal income tax on capital gain from a sale transaction for potentially many years, the amount of capital gain subject to tax, once due, can be reduced by up to 15%. Such gain, when finally taxed, will likely be subject to the investor’s income tax rate in effect at the time such tax is required to be paid. Therefore, when considering an investment in an opportunity fund, thought should be given as to the potential risk of income tax rates rising between the time of making such an investment and the end of the deferral period when the investor is required to pay tax on the original deferred gain.
The third principal benefit of the opportunity zone program is where the taxpayer holds an interest in the opportunity fund for at least 10 years. In such a case, the taxpayer may make an election to increase the tax basis of his investment in the opportunity fund to the investment’s fair market value on the date of a sale of such interest, thereby eliminating any taxable gain on the appreciation of the taxpayer’s investment in the opportunity fund. This is where much of the excitement in the opportunity zone program has been generated because this benefit permits the taxpayer to continue to obtain tax-free appreciation on his opportunity fund investment as long as the taxpayer disposes of such investment on or before December 31, 2047.
Because the above-noted tax benefits are U.S. federal income tax benefits, they should be available to all eligible taxpayers who are subject to U.S. federal income tax and generate capital gains sourced in the U.S., including Canadians who have taxable capital gain from the sale of a company, business, real property or other capital assets in the U.S. (Canadians, as well as other non-U.S. persons should nevertheless consult with their own tax advisors as to how these tax benefits and other aspects of the opportunity zone program may be treated under the tax laws for their own jurisdiction).
The opportunity zone program is an exciting new tax incentive program that aims to promote capital investment in economically disadvantaged communities in the U.S. by offering substantial federal income tax benefits to opportunity fund investors. This article touches only on a few key aspects of the opportunity zone program. The program is subject to many other pertinent details, rules and limitations, as well as continuing development by the U.S. Department of the Treasury and the IRS of further regulations and related guidance. As such, this article should not be construed as a complete discussion of the opportunity zone program. Persons interested in learning more about the program can contact the authors through the email addresses noted below.
Garth D. Stevens (firstname.lastname@example.org) is a corporate and securities partner at Snell & Wilmer L.L.P. and a member of the board of directors of MAPLE Business Council. Marc L. Schultz (email@example.com) is a federal tax partner at Snell & Wilmer L.L.P. Both are actively involved in opportunity zone fund formation.