Passed in the waning days of 2017 and taking effect Jan. 1, 2018, the Tax Cuts and Jobs Act made significant changes to provisions of the Internal Revenue Code dealing with the treatment of capital gains.
On the one hand, the Act took away the ability to defer capital gains on the sale of tangible and intangible personal property by limiting capital gain deferral under Section 1031 to gains from the sale of real property only.
On the other hand, the Act established a new set of incentives for the investment of realized capital gains into “Qualified Opportunity Zones” -- census tracts that meet the U.S. Treasury Department’s definition of “low income.”
According to the Treasury Department listing, there are 120 designated Qualified Opportunity Zones spread throughout the State of Wisconsin.
Requirements of the Opportunity Zone Program
Under the new program, a taxpayer may, within 180 days after recognizing a capital gain, reinvest that gain into a Qualified Opportunity Fund (QOF). Under the program’s proposed regulations, only long-term capital gains appear to be eligible to be reinvested in a QOF. The amount of gain which the taxpayer seeks to defer must be invested as cash.
The QOF may be organized as a corporation or partnership for tax purposes, but may not be a disregarded entity.
The QOF then invests in a Qualifying Opportunity Zone Business (QOZB), either directly or through an intermediate entity.
A QOZB is a business that meets these requirements:
Substantially all of the QOZB’s owned or leased property is “Qualified Opportunity Zone Business Property,” which is defined as tangible property (i) purchased after Dec. 31, 2017, and (ii) the use of which must occur within the Qualifying Opportunity Zone.
In addition, to be considered as Qualified Opportunity Zone Business Property, the QOF must either commence the use of the property at the same time that the QOF commences operation, or the QOF must substantially improve the property within 30 months of the property’s acquisition by the QOF.
At least 50 percent of the QOZB’s income is derived from the “active conduct of a trade or business” within the Qualified Opportunity Zone.
A substantial portion of any of the QOZB’s intangible property is used in the conduct of business with the Qualified Opportunity Zone.
Less than five percent of the average of the aggregate unadjusted basis of the QOZB’s property is attributable to “nonqualified financial property,” as that term is defined in Section 1397C(e) of the Internal Revenue Code.
At least 90 percent of the QOF’s assets much be invested in a QOZB. The 90 percent holding requirement is tested every six months, including at the end of the QOF’s tax year.
If the 90 percent requirement is not met, the QOF is subject to monetary penalties. As is the case with many other tax incentives, certain businesses, such as public private golf courses, massage parlors, tanning salons, gambling facilities, racetracks, and liquor stores are not eligible QOZBs.
Benefits of the Opportunity Zone Program
Assuming that the alphabet soup of program’s requirements can be met, the taxpayer can reap significant benefits, including:
deferral of capital gains tax on the taxpayer’s original invested capital gain until the earlier of the date that the QOF investment is sold or Dec. 31, 2026;
if the QOF investment is maintained for at least five years, the taxpayer can permanently exclude a portion of the original invested capital gain from tax, which would effectively result in a 10 percent gain reduction if the QOF investment is held for at least five years, and a 15 percent gain reduction if the QOF investment is held for at least seven years; and
if the QOF investment is maintained for at least 10 years, the taxpayer can increase the basis in his or her interest in the QOF to 100 percent of its fair market value on the date of sale, effectively exempting the capital gain from the ultimate sale of the QOF interest from tax.
Taxpayers Should Move Quickly
Because of the various deadlines and required holding periods, taxpayers wishing to take full advantage of the new program will have to move quickly. Capital gain needs to be initially invested in a QOF within 180 days of recognition.
In order to receive the benefit of the reductions in capital gains tax noted above, the taxpayer must invest by Dec. 31, 2019 (to be eligible for the 15 percent reduction), or by Dec. 31, 2021 (to be eligible for the 10 percent reduction).
In order to receive the benefit of the complete exemption from capital gains tax for the sale of a QOF investment maintained for at least 10 years, the investment must be made by Dec. 31, 2028, which is the sunset date of the program.
Comparing Benefits with Traditional Deferral
In two important respects, the program provides a comparative benefit to the more traditional method of capital gain deferral under Section 1031 of the Internal Revenue Code.
First, while 1031 exchanges require that the entire value of the relinquished property be reinvested, a taxpayer need only invest the actual amount of his or her capital gain in a QOF, meaning that gain deferral is available for a potentially much smaller investment.
Second, while 1031 exchanges are now limited to exchanges of real property, almost any capital gain, whether from real or personal, tangible or intangible property, may be invested in a QOF.
Proposed regulations for the Opportunity Zone program were issued Oct. 19, 2018, and in many respects, were extremely favorable to investors. While the statute required that the IRS promulgate rules for the certification of COFs, the proposed regulations indicate that QOFs may self-certify (unlike, for example, the much more rigorous certification requirements for community development entities under the New Market Tax Credit program).
The regulations also allow a QOF up to 31 months to actually deploy funds by investing in a Qualified Opportunity Zone, while at the same time providing immediate gain deferral for funds invested in the COF.
By defining “substantially all” for purposes of determining the amount of a QOZB’s owned or leased property which must be located within a Qualifying Opportunity Zone as 70 percent, the regulations permit a QOZB to hold significant assets outside of a Qualified Opportunity Zone.
One of the biggest issues not resolved in the proposed regulations is the definition of “active conduct of a trade or business” for purposes of determining whether a business qualifies as a QOZB.
“Active conduct of a trade or business” has no single definition within the Internal Revenue Code. For example, in the context of tax-free spinoffs, “active conduct of a trade or business” requires that a taxpayer be engaged in active and substantial management and operational functions.
By contrast, in the context of New Market Tax Credits, “active conduct of a trade or business” requires only that the taxpayer reasonably expect to generate revenues within a certain period following an initial investment.
Further complicating matters, the Internal Revenue Code provisions dealing with enterprise zones, which are the source for several other definitions applicable to the Opportunity Zone program, specifically exclude the rental of residential real estate from the definition of “qualified business.”
Given the purposes of the Opportunity Zone program, utilizing the New Market Tax Credit definition of “active conduct of a trade or business” would make greater sense, as it would facilitate redevelopment by permitting the development and leasing of property on a triple net basis, which would likely not be permitted using a more restrictive definition.
Additionally, as the creation of affordable housing is a major issue for many low-income areas, it would be odd to exclude residential leasing from the permissible business functions of a QOZB. The final rules, when issued, will hopefully provide some further guidance with respect to this issue.
Conclusion: A Powerful New Tool
The Opportunity Zone program is a powerful new tool for the deferral and potential reduction of capital gains while incentivizing investment in the most distressed areas of the country.
Because the proposed regulations are so flexible, however, the degree to which investments made under the program will actually target the low-income communities that they are intended to benefit remains to be seen.