Qualified Opportunity Zones and Funds – What’s the Big Deal?
The Tax Cuts and Jobs Act added the concept of “Qualified Opportunity Zones” to the tax code on December 22, 2017. In short, a “Qualified Opportunity Zone” is a low-income community that has been nominated by the state and certified by the US Treasury. The State of California’s Department of Finance has published a list of over 800 tracts of land across 57 counties within California that have been designated as Qualified Opportunity Zones.
So, what’s the big deal?
Investment in a Qualified Opportunity Zone has significant tax benefits. To be eligible for these benefits the investment must come from capital gains[1] stemming from the sale to, or exchange with, an unrelated person (20% rule) of any property held by the taxpayer (e.g., stock, real estate, etc.). The investment must also be made within 180 days of the date of the prior sale or exchange.
Okay, so assuming I hit those requirements, what are the benefits?
First, the tax that would otherwise be due on the invested capital gains is deferred until the earlier to occur of (1) the date the investment is sold or exchanged or (2) December 31, 2026 (as applicable, the “Tax Date”).
Second, at the Tax Date, the taxable gain recognized will be equal to the lesser of (1) the gain previously excluded or (2) the fair market value of the investment as of the Tax Date.
Is that all?
No. If the taxpayer holds the investment for five years, the taxpayer’s basis in the investment is automatically increased so that only 90% of the previously excluded gain is taxable. If the investment is held for seven years, the taxpayer’s basis in the investment is automatically increased so that only 85% of the previously excluded gain is taxable.
For example, say taxpayer Tim invests $1,000,000 into a Qualified Opportunity Zone, all of which represents gain from the prior sale of other investment property. Tim makes the investment on July 1, 2019 and holds the investment through December 31, 2026. In 2019, he recognizes no gain from the prior sale and his basis in the new investment is treated as $0. On July 1, 2024, Tim’s basis in the investment is automatically increased to $100,000 (equal to 10% of the deferred gain – meaning that, at most, only $900,000 remains taxable). On July 1, 2026, Tim’s basis in the investment is automatically increased by another $50,000 to a total of $150,000 (meaning that, at most, only $850,000 remains taxable).
Using the above, consider the following scenarios:
Scenario 1: On December 31, 2026, the fair market value of the investment is only $900,000. Therefore, on December 31, 2026, Tim must recognize gain of only $750,000 ($900,000 fair market value (which is less than the original $1,000,000 of deferred gain) less $150,000 of increased basis).
Scenario 2: On December 31, 2026, the fair market value of the investment is $2,000,000. Therefore, on December 31, 2026, Tim must recognize gain of only $850,000 (original $1,000,000 of deferred gain (which is less than the fair market value) less $150,000 of increased basis
Okay, is that all?
No. Following recognition of the applicable gain as of the Tax Date, if the taxpayer holds the investment for at least 10 years from the date of investment, the investment effectively grows tax free.
Using Scenario 1 from our prior example, Tim recognizes $750,000 of gain on December 31, 2026 at the time that the investment’s fair market value is worth $900,000. Tim’s basis in the investment is increased at such time to $900,000. On December 31, 2029, Tim sells the investment for $5,000,000. At the time of such sale, Tim may elect to have his basis in the investment increased to the sale price of $5,000,000. The result is that Tim pays no tax on the increase.
One important caveat is that the proposed regulations provide that the investment must be sold no later than December 31, 2047 in order to benefit from the foregoing.
Okay! I’m in!
Not so fast. There are entry barriers and obligations. First, the only way to participate in a Qualified Opportunity Zone is through a “Qualified Opportunity Fund” meaning a corporation or partnership organized for the purpose of investing in “Qualified Opportunity Zone Property.” “Qualified Opportunity Zone Property” essentially means (1) property within a Qualified Opportunity Zone (for purposes of this article, “Option 1”) or (2) interests in a business of which substantially all of its tangible property is located within a Qualified Opportunity Zone (for purposes of this article, “Option 2”).[2]
Option 1: If the fund proceeds under Option 1, 90% of the assets held by the fund must be “Qualified Opportunity Zone Business Property” (i.e., tangible property within a Qualified Opportunity Zone used in a trade or business, acquired after December 31, 2017, and to which the original use commenced with the Qualified Opportunity Fund or to which the fund makes substantial improvements).
The primary scenario at this point is one in which the fund acquires already developed property and proceeds to improve the structures thereon. Pursuant to Revenue Ruling 2018-29, the fund is not required to improve the land and, by implication, it appears that the land itself counts towards the 90% asset rule so long as the structures are improved. That said, the fund must make substantial improvements to the structures on the property within any 30 month period beginning at the date of acquisition. In short, the fund must double the amount invested into the structures on the property to satisfy the substantial improvement requirement.
Using and expanding upon our prior example, Tim invests $1,000,000 into Qualified Opportunity Fund A (“Fund A”). Fund A, after obtaining other investors, spends $10,000,000 on a factory within a Qualified Opportunity Zone. $3,000,000 of the purchase price is allocated to the underlying land. $7,000,000 of the purchase price is allocated to the actual factory building and improvements. Accordingly, in order for Fund A to be eligible for the tax benefits described above, Fund A must, within any 30 month period, spend another $7,000,000 improving the property.
It is important to note that the rules are not yet well-defined regarding how unimproved land is treated and what would therefore constitute “substantial improvement.” One reasonable interpretation would be that at least 90% of the assets of the fund be utilized to build improvements upon the unimproved land, thereby satisfying the 90/10 requirement.
Option 2: If the fund proceeds under Option 2, the rules vary.[3] Although 90% of the fund’s assets must still be in Qualified Opportunity Fund Property, the fund can satisfy this requirement more easily by ownership of stock or partnership interests in a business that holds Qualified Opportunity Zone Business Property. The underlying business is then obligated to satisfy the requirements discussed above, including but not limited to substantially improving the structures on the property. This model does, however, currently provide more flexibility in satisfying the requirements. Curiously, and as an example of such flexibility and one of the substantial differences between Option 1 and Option 2, the underlying business is only required to have 70% of its assets as Qualified Opportunity Zone Business Property.
Conclusion
The foregoing article provides a basic overview of the ups and downs related to investments in Qualified Opportunity Funds. The fact remains though that this is an entirely new area of the law and one that is still pending final regulations. Accordingly, the rules are subject to change and related IRS interpretations.
In closing, there is still much regarding Qualified Opportunity Funds that we do not yet know. However, as of the date of this article, the evidence surrounding them indicates that the IRS wants them to work and as such, they may be a very lucrative investment vehicle for individuals who also desire to make a positive impact on less fortunate areas.
[1] Other funds may be invested but they do not qualify for the benefits described herein.
[2] There is no requirement that a fund choose one option over the other, or to the exclusion of the other option.
[3] A full analysis of the variations between Option 1 and Option 2 is beyond the scope of this article.