OPPORTUNITY ZONE SUMMARY (Tax Cuts and Jobs Act of 2017)
What is an Opportunity Zone investment?
A new tax incentive for investment in low-income areas designated as “Opportunity Zones” was included in the Tax Cuts and Jobs Act of 2017, signed into law on December 22, 2017. Under this section of the Act, codified as sections 1400Z-1, and 1400Z-2 of the Internal Revenue Code, taxpayers with taxable capital gains from the sale of any asset (stock, property, etc.) who reinvest those gains within 180 days of the date of sale of the asset into “Qualified Opportunity Zone Property” will become eligible to receive significant tax benefits. These potential tax benefits are expected to result in substantial new investment by investors in real estate projects that meet the requirements of “Qualified Opportunity Zone Property.” This article explains what the requirements are for designation as Qualified Opportunity Zone Property, and discusses the structure of Opportunity Zone investments.
What are the potential benefits to persons who invest in a Qualified Opportunity Zone Property?
There are three potential benefits that investors may receive from an investment of their taxable capital gains into a Qualified Opportunity Zone Property:
Deferral of Capital Gains Tax – Investors will receive a deferral of taxation on 100% of the taxable capital gains invested in Qualified Opportunity Zone Property until the earlier of the date that their investment is sold or December 31, 2026;
Reduction of Capital Gains – Investors who invest by December 31, 2019 will be eligible to receive a 10% reduction of the taxable gain amount invested in Qualified Opportunity Zone Property if the investment is retained for at least 5 years, increasing to a 15% reduction if the investment is held for at least 7 years; and
No Tax on Capital Gains realized on Qualified Opportunity Zone Property – Investors who invest by December 31, 2019 and hold their investment in a Qualified Opportunity Zone Property will pay no tax on any capital gains realized when that investment is sold.
Step 1. Taxpayer recognizes capital gain on the sale of assets.
Step 2. Within 180 days, the taxpayer reinvests some or all of that gain in a qualified opportunity fund (QOF).
Step 3. The QOF,in turn, must invest more than 90% of its assets in qualified opportunity zone property (QOZP) located within a qualified opportunity zone (QOZ), either by:
Step 4, Investing in a subsidiary that operates a qualified opportunity zone business (QOZB), or
* Operating a QOZB directly by holding qualified opportunity zone business property (QOZBP).
- The QOF, in turn, has a choice. It can either 1) conduct a qualified opportunity zone business directly, by investing more than 90% or more of its assets in qualified opportunity zone business property, or
- B) the QOF can conduct a qualified opportunity zone business indirectly, by acquiring stock in a corporation or an interest in a partnership. In the latter case, at least 70% of the assets of the corporation or partnership must meet the definition of qualified opportunity zone business property. And because only 90% of the assets of the QOF must be qualified opportunity zone property, then as little as 63% of the total property of the QOF must be used in a qualified opportunity zone business.
Step 5 Improvements must be done within 30 months and be double the adjusted basis of the original purchase. See computation of adjusted basis- Bldg-land value= adjusted basis.
What are the requirements for Qualified Opportunity Zone Property?
There are four primary requirements for a real estate development to achieve the status of “The property must be acquired by purchase for cash after December 31, 2017; and
- The property must be either (a) new construction that is not put into use until after the purchase of the property; or (b) “substantially improved” after purchase of the property, which requires that the costs of constructing, renovating or expanding the property during any 30-month period beginning after the date of the acquisition of the property must exceed 100% of the adjusted basis of the property at the start of the 30-month period.
- Can Opportunity Zone funds be used for property that is already completed and in operation?
Reduction of Capital Gains – Investors who invest by December 31, 2019 will be eligible The Code states that the “original use” of the property must commence with the qualified opportunity fund, or the qualified opportunity fund must substantially improve the property. This would generally require that a property not be completed prior to investment by Opportunity Zone investors. Alternatively, if the property has previously been completed, the property would have to be substantially improved after the investment with Opportunity Zone funds. Substantial improvement is defined as improvements that add to the basis of the property an amount at least equal to 100% of the original basis of the property and that are completed within a period of 30 months beginning with the date of acquisition of the property.
- What is a Qualified Opportunity Fund and is it required to be approved by the IRS?
- A Qualified Opportunity Fund is defined in the Code as any investment vehicle organized as a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone Property that holds at least 90% of its assets in “Qualified Opportunity Zone Property,” as measured on the last day of the first 6-month period of the taxable year of the fund and on the last day of the taxable year of the fund. The term “Qualified Opportunity Zone Property” is defined to include stock or partnership interests in a company that is a qualified opportunity zone business, or a direct investment in a qualified opportunity zone business property. There is no requirement that Qualified Opportunity Fund be approved or certified by any governmental entity. There is a self-certification form that the sponsor of a Qualified Opportunity Fund files with the IRS to declare that it intends to comply with the requirements to be a Qualified Opportunity Fund.
- Does a developer have to set up its own Qualified Opportunity Fund or can it accept investments from other Qualified Opportunity Funds?
- A developer could set up its own corporation or partnership (and we expect this will be defined by the IRS to include a limited liability company taxed as a partnership) that the developer controls, which is a Qualified Opportunity Fund. Alternatively, the developer could set up a property owner entity that could accept outside investments from other Qualified Opportunity Funds that are set up by third parties. There have already been several Opportunity Funds established as “blind pools,” for the purpose of seeking and investing in Qualified Opportunity Zone Business Property. A developer could potentially seek investment from these independent Opportunity Funds. Alternatively, a developer that already has experience in raising capital could establish its own Qualified Opportunity Fund. There are no restrictions regarding the ownership or control of a Qualified Opportunity Fund, or its relationship to the property owner or developer.
- Are there any required terms that must be included in a Qualified Opportunity Fund entity?
- We know some of the terms that should be included in the partnership agreement or operating agreement of a Qualified Opportunity Fund. There are also some terms that require clarification from the IRS, and we expect that the IRS will issue regulations that will clarify some of these issues. Here is a brief summary of the terms that should be included in the partnership agreement or operating agreement of an Opportunity Fund:
- The investors in the Opportunity Fund must invest in equity – they cannot invest in debt.
- The Opportunity Fund should be authorized to invest solely in Qualified Opportunity Zone Business Property;
- The Opportunity Fund should have restrictions on distributions of proceeds of sale of Qualified Opportunity Zone Business Property, because investors are required to hold their investment in the Opportunity Zone Fund for at least 10 years if they wish to be eligible to realize the gains on their investment in the Opportunity Fund without taxation of those gains;
- The Opportunity Fund should provide authorization for reinvestment of the proceeds of sale of Qualified Opportunity Zone Business Property into one or more other Qualified Opportunity Zone Business Properties; (Whether the IRS will allow for sale and reinvestment is an open issue that we anticipate will be addressed in regulations.);
- The Opportunity Zone Fund could provide for distributions of net cash flow from operations of the opportunity zone property, but the IRS has not provided guidance on distributions, so the manager or general partner of the Opportunity Fund should retain discretion to determine when distributions will be made and how distributable cash will be determined, to conform to IRS regulations.
- Can a developer use debt as well as equity to fund a property and still be a Qualified Opportunity Zone Business?
- Yes, a developer can still obtain a senior mortgage loan secured by the property, or other debt financing for the property. The investors in the Opportunity Zone Fund must contribute equity, not debt, but this does not limit the ability of the property owner to obtain debt as an additional source of financing for the property. In fact, a developer could obtain multiple sources and types of debt and equity financing, and still be qualified to accept Opportunity Fund investments as one part of the capital stack.
- What does this mean for real estate developers seeking to use Opportunity Zone Funds to finance real estate development?
- The potential tax benefits are expected to provide a substantial incentive for investors to make equity investments in new businesses located in the designated Opportunity Zones. This means that new investors will be actively seeking investments that will qualify for these benefits. In particular, a surge of new investor interest is expected to occur over the next year. This will likely expand the pool of potential investors, as well as the dollar amount of capital available, for real estate development in the Opportunity Zone areas. Real estate developers should act quickly to determine if one or more of their real estate developments will qualify for investment from Opportunity Funds, and if so, consult with their legal and tax counsel about the steps necessary to bring this new source of capital into their developments.
- If I want to use the deferral/exclusion provisions of Section 1400Z-2, then within 180 days of recognizing a capital gain, I need to invest in a QOF.
The whole idea of the Opportunity Zones tax law is to connect investor capital with low-income areas of the country that may have the greatest need for reinvestment. Going along with the spirit of the law, IRC Sec. 1400Z-2(d)(2)(D)(i) states that qualified opportunity zone property held by a qualified opportunity fund must satisfy one of the following requirements:
- The original use of qualified opportunity zone property commences with the qualified opportunity zone fund, or
- The qualified opportunity zone fund substantially improves the property
- As clarified in the recent Revenue Ruling by the IRS, the term substantially improvesmeans that taxpayers must double their adjusted basis in the property after purchase and during any 30-month period that they hold their qualified opportunity zone property. The additions to basis must exceed the adjusted basis in the property at the beginning of such 30-month period. Land is excluded from the adjusted basis calculations.
- Example – Redevelopment
- QOF A purchased a vacant office building located in a qualified opportunity zone. The QOF purchased the building for $1,000,000. Of the $1,000,000 purchase price, 60% is allocated to the building value ($600,000) and 40% is allocated to the land value ($400,000). Therefore, during any 30-month period, QOF A must substantially improvethe property by increasing the adjusted basis in the building by whatever the adjusted basis is at the beginning of the 30-month period. So, for the first 30-month period after the purchase, an additional $600,000 (the amount allocated to the building at the time of purchase) of substantial improvements are necessary. A year after purchasing the building, QOF A spends $750,000 and 15 months to redevelop the building and build out spaces for incoming tenants, thereby satisfying the substantial improvement clause.
- In order to satisfy this substantial improvement provision, it may be best to consider real estate investments in qualified opportunity zones in which a development or redevelopment opportunity is the best use of the underlying property.
- Layering Opportunity Zone Incentives
- It may be beneficial for investors and developers to layer a qualified opportunity zone investment with other federal, state, and local incentives that already exist.
As part of a separate tax law resulting from the recently passed Tax Cuts and Jobs Act, businesses may take 100% bonus depreciation on qualified property placed into service before January 1, 2023. As the chart above shows, a taxpayer may make effective use of the 100% bonus depreciation window in connection with the need to satisfy the “substantial improvement” (doubling of adjusted basis) in any 30-month time period during the opportunity zone deferral period. By overlapping the development/redevelopment/build out costs needed to satisfy the “substantial improvement” clause related to opportunity zone property, taxpayers may see additional benefits by electing 100% bonus depreciation for eligible property.
It is important to note that a taxpayer must “substantially improve” (double adjusted basis) the qualified opportunity zone property within any 30-month period – it does not have to be within the first 30 months of purchasing the QOZ
State and Local Incentives
Many states and local governments may have their own pre-existing incentive programs to encourage development, investment, and job creation in low-income areas, such as those that have been designated as qualified opportunity zones.
If a QO Zone investment is being considered in an existing real property, and knowing that the adjusted basis will need to be doubled in any 30-month period, consideration should be given to speaking with local government officials and tax advisors to consider what federal, state, and local incentive programs may be available
Internal Revenue Service
Opportunity Zones Frequently Asked Questions
- What is an Opportunity Zone?
- An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.
- How were Opportunity Zones created?
- Opportunity Zones were added to the tax code by the Tax Cuts and Jobs Act on December 22, 2017.
- Have Opportunity Zones been around a long time?
- No, they are new. The first set of Opportunity Zones, covering parts of 18 states, were designated on April 9, 2018. Opportunity Zones have now been designated covering parts of all 50 states, the District of Columbia and five U.S. territories.
- What is the purpose of Opportunity Zones?
- Opportunity Zones are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities.
- How do Opportunity Zones spur economic development?
- Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain. If held for more than 7 years, the 10% becomes 15%. Second, if the investor holds the investment in the Opportunity Fund for at least 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.
- What is a Qualified Opportunity Fund?
- A Qualified Opportunity Fund is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in a Qualified Opportunity Zone.
- Do I need to live in an Opportunity Zone to take advantage of the tax benefits?
- No. You can get the tax benefits, even if you don’t live, work or have a business in an Opportunity Zone. All you need to do is invest a recognized gain in a Qualified Opportunity Fund and elect to defer the tax on that gain.
- I am interested in knowing where the Opportunity Zones are located. Is there a list of Opportunity Zones available?
- Yes. The list of designated Qualified Opportunity Zones can be found at Opportunity Zones Resourcesand in the Federal Register at IRB Notice 2018-48. Further a visual map of the census tracts designated as Qualified Opportunity Zones may also be found at Opportunity Zones Resources [link].
Q: What do the numbers mean on the Qualified Opportunity Zones list, Notice 2018-48?
A: The numbers are the population census tracts designated as Qualified Opportunity Zones.
Q: How can I find the census tract number for a specific address?
A: You can find 11-digit census tract numbers, also known as GEOIDs, using the U.S. Census Bureau’s Geocoder. After entering the street address, select ACS2015_Current in the Vintage drop-down menu and click Find. In the Census Tracts section, you’ll find the number after GEOID.
- I am interested in forming a Qualified Opportunity Fund. Is there a list of Opportunity Zones available in which the Fund can invest?
- Yes. The list of designated Qualified Opportunity Zones in which a Fund may invest to meet its investment requirements can be found at Notice 2018-48.
- How does a corporation or partnership become certified as a Qualified Opportunity Fund?
- To become a Qualified Opportunity Fund, an eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return. Early-release drafts of the formand instructionsare posted, with final versions expected in December. The return with Form 8996 must be filed timely, taking extensions into account.
Q: Can a limited liability company (LLC) be an Opportunity Fund?
A: Yes. A LLC that chooses to be treated either as a partnership or corporation for federal tax purposes can organize as a Qualified Opportunity Fund.
- I sold some stock for a gain in 2018, and, during the 180-day period beginning on the date of the sale, I invested the amount of the gain in a Qualified Opportunity Fund. Can I defer paying tax on that gain?
- Yes, you may elect to defer the tax on the amount of the gain invested in a Qualified Opportunity Fund. Therefore, if you only invest part of your gain in a Qualified Opportunity Fund(s), you can elect to defer tax on only the part of the gain which was invested.
- How do I elect to defer my gain on the 2018 sale of the stock?
- You may make an election to defer the gain, in whole or in part, when filing your 2018 Federal Income Tax return. That is, you may make the election on the return on which the tax on that gain would be due if you do not defer it.
- I sold some stock on December 15, 2017, and, during the required 180-day period, I invested the amount of the gain in a Qualified Opportunity Fund. Can I elect to defer tax on that gain?
- Yes. You make the election on your 2017 return. Attach Form 8949, reporting Information about the sale of your stock. Precise instructions on how to use that form to elect deferral of the gain will be forthcoming shortly.
- Can I still elect to defer tax on that gain if I have already filed my 2017 tax return?
- Yes, but you will need to file an amended 2017 return, using Form 1040Xand attaching Form 8949.
- How can I get more information about Opportunity Zones?
- Over the next few months, the Treasury Department and the Internal Revenue Service will be providing further details, including additional legal guidance, on this new tax benefit. More information will be available at Treasury.gov and IRS.gov.
Page Last Reviewed or Updated: 05-Nov-201
In the above example of the difference in investing in Opportunity Zones vs 8% gain in alternative investment:
$1,000,000 capital gain
($238,000) est. taxes
$762,000 Bal to invest
$1,645,101 8% return
$210,178 pay cap gain tax
$1,434,923 Balance of funds
Opportunity Zone investment
$1,000,000 cap gain investment (capital gain from prior investment is deferred for up to 7 yrs)
($850,000 capital gain ($1,000,000 pay cap gains tax at 85% of prior cap gain)
$2,158,925 value of original $1,000,000 investment in Opportunity Zone at 8% return
($277,716) est. tax paid on prior cap gain and lost earnings in O Zone purchaes -3 yrs
$1,931,209 Balance of funds
Conventional Investment in 10 yrs Opportunity Fund Investment in 10 yrs
Note: Opportunity Zone Property may be held for up to 30 Yrs
Answer: Land will not likely qualify under the “original use” standard under the opportunity zones statute. Therefore, land will likely need to be substantially improved to qualify. Land may qualify as substantially improved property through a sufficient amount of new construction or through the substantial improvement of an existing building located on the land. However, it is likely that only the portion of the land that is integral to the business using such improvements will qualify.
Example: A qualified opportunity fund (QOF) purchases 100 acres of vacant land in an opportunity zone for $5 million and builds a hotel for $10 million. Only 10 acres of the land is integral to the hotel business. QOF made $400,000 of improvements to the remaining 90 acres and used it in a farming business. QOF will likely have $10.5 million of qualified opportunity zone business property and $4.9 million of nonqualified property assuming that land can be substantially improved.
The term “qualified opportunity zone business property” means tangible property used in a trade or business of the qualified opportunity fund if:
- such property was acquired by the qualified opportunity fund by purchase after Dec. 31, 2017,
- the original use of such property in the qualified opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund substantially improves the property, and
- during substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
Original use is not defined in the opportunity zones statute.
Under a similar “original use” standard found in the Gulf Opportunity Zone (GO Zone) bonus depreciation incentive, original use means the first use to which the property was put, whether or not that use corresponds to the use of the property by the taxpayer.
The GO Zone definition of original use also incorporates rules similar to the following rules for “original use” found under general bonus depreciation guidance:
- If a taxpayer initially acquires new property for personal use and subsequently uses the property in the taxpayer’s trade or business or for the taxpayer’s production of income, the taxpayer is considered the original user of the property.
- If a person initially acquires new property for personal use and a taxpayer subsequently acquires the property from the person for use in the taxpayer’s trade or business or for the taxpayer’s production of income, the taxpayer is not considered the original user of the property.
- If a taxpayer initially acquires new property and holds the property primarily for sale to customers in the ordinary course of the taxpayer’s business and subsequently withdraws the property from inventory and uses the property primarily in the taxpayer’s trade or business or primarily for the taxpayer’s production of income, the taxpayer is considered the original user of the property.
- If a person initially acquires new property and holds the property primarily for sale to customers in the ordinary course of the person’s business and a taxpayer subsequently acquires the property from the person for use primarily in the taxpayer’s trade or business or primarily for the taxpayer’s production of income, the taxpayer is considered the original user of the property.
Under this “original use” guidance, land could not meet the definition of qualified opportunity zones business property because, by its very nature, it would have been used before (personally or for business use) in the opportunity zone. Accordingly, it appears that land would have to be substantially improved to qualify.
Substantial Improvement Under the qualified opportunity zone business property rules, property is treated as substantially improved only if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.
The opportunity zones statute does not specifically address whether land can be substantially improved through the new construction, or substantial improvement of a building located on the land. Nor does it address whether the reference to “such property” under the substantial improvement provision includes the integrated pair of building and land.
An analogous standard under Internal Revenue Code Section 1400B–allowing for the exclusion of gain on District of Columbia (DC) Zone business property–provides that original use of property commencing with the taxpayer is treated as met with respect to property that is substantially improved including any land that that property is located. The legislative history of this DC Zone statute provides that land that is not an integral part of a DC Zone business be excluded from the definition of DC Zone business property. Therefore, under the DC Zone incentive, land does not appear to have to be substantially improved to qualify as long as the land is integral to the business using the building that has been substantially improved. The opportunity zones statute does not have a similar path to qualify land.
Based upon the similar DC Zone substantial improvement standard, it is reasonable to suppose that taxpayers might be able qualify land through new construction or substantial improvements that exceed the beginning basis of the land (or land and existing building in the case of a substantially improved building) as long as the land is integral to the business using such improvements. Although, until we receive further guidance from Treasury, we cannot know for sure.