Opportunity Zone Program offers a New Tax Efficient Vehicle for Investors and Developers

Background

On December 22, 2017, President Donald Trump signed into law the Tax Cuts and Jobs Act (the “Act”), which contained a potentially lucrative tax incentive program (the “Opportunity Zone Program”) to encourage long-term investments in low-income communities identified as “opportunity zones” by certain jurisdictions (i.e., states, territories, possessions, and the District of Columbia). The Opportunity Zone Program offers developers, including start-up companies developing new technologies in the energy, chemical, and infrastructure industries, an exciting, new opportunity to attract private placement funds into business operations and projects constructed in such opportunity zones. Under the Act, the Opportunity Zone Program allows investors to:

• Defer recognition of capital gains until December 31, 2026 if those gains are invested in qualified opportunity funds (“QOFs”) (discussed below);

• Exclude from taxable gross income up to 15% of the deferred capital gains (if certain holding periods are met); and

• Exclude from taxable gross income any post-investment gains from the disposition of such investments if the investments are held for at least 10 years.

On October 19, 2018, the Department of Treasury and the Internal Revenue Service issued initial proposed regulations and guidance for the Opportunity Zone Program. The proposed regulations clarify, among other things, the types of capital gains that are eligible for deferral, the requirements for QOFs, and certain partnership tax questions.

Definitions

1. Eligible Taxpayers

   Eligible taxpayers under the Opportunity Zone Program include any taxpayer that may recognize gains for the purposes of Federal income tax accounting, including but not limited to individuals, C corporations (including “regulated investment companies” and “real estate investment trusts”), and partnerships (including LLCs taxed as partnerships).¹

   In the case of a partnership or LLC taxed as a partnership electing deferral under the Opportunity Zone Program, the deferred gain is not included in the distributive shares of the partners under section 702 of the Internal Revenue Code of 1986, as amended (the “Code”). To the extent the partnership does not defer eligible gains, such eligible gains are included in the distributive shares of the partners, and provided all other requirements are met, each partner may individually elect deferral with respect to their distributive shares.²

2. Eligible Gains

   Gains that are eligible for deferral under the Opportunity Zone Program are gains that:

   1. Are treated as capital gain for Federal income tax purposes;
   2. Would otherwise be recognized for Federal income tax purposes before January 1, 2027; and
   3. Do not arise from a sale or exchange with a “related person”.³
      • The term “related person” is the same as defined in sections 267(b) and 707(b)(1) of the Code, except that “20 percent” is substituted each time “50 percent” appears in such sections.⁴
3. Qualified Opportunity Funds

   A QOF is any investment vehicle which is 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 (the “90% Test”).⁵

   • Eligible entities may self-certify as a QOF.
   • Pre-existing entities may be used as a QOF or as a subsidiary operating entity.
   • The 90% Test is determined by an average of the percentage of qualified opportunity zone property held as measured on:
     • The last day of the first 6-month period of the taxable year of the QOF; and
     • The last day of the taxable year of the fund.
   • For the purpose of the 90% Test, QOFs are required to use asset values reported on the QOF’s applicable financial statement for the taxable year, or if the QOF does not have an applicable financial statement, the cost of its assets.
     • Cash may be counted towards the 90% Test for up to 31 months if:
       • There is a written plan that identifies financial property as held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone;
       • There is a written schedule consistent with the ordinary business operations of the business that the property will be used within the 31 months; and
       • The business substantially complies with the schedule.
4. Qualified Opportunity Zone Property
   

   Qualified opportunity zone property includes⁶:

   1. Qualified opportunity zone stock – stock in a domestic corporation if:
      • The stock was acquired by a QOF after December 31, 2017 at its original issue from the corporation solely in exchange for cash;
      • At the time such stock was issued, such corporation was a qualified opportunity zone business; and
      • During substantially all of the QOF’s holding period for such stock, such corporation qualified as a qualified opportunity zone business.
   2. Qualified opportunity zone partnership interest – capital or profits interest in a domestic partnership (or LLC taxed as a partnership) if:
      • Such interest is acquired by the QOF after December 31, 2017 from the partnership solely in exchange for cash;
      • At the time such interest was acquired, such partnership was a qualified opportunity zone business; and
      • During substantially all of the QOF’s holding period for such interest, such partnership qualified as a qualified opportunity zone business.
   3. Qualified opportunity zone business property – tangible property used in a trade or business of the QOF if:
      • Such property is acquired by the QOF after December 31, 2017 by purchase;
      • The original use of such property in the qualified opportunity zone commences with the QOF or the QOF substantially improves the property; and
        • A property is substantially improved by a QOF if, during any 30-month period beginning after the date of acquisition, additions to basis with respect to the property by the QOF exceed the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF.
        • If a QOF purchases a building on land that is wholly within a qualified opportunity zone, substantial improvement of such building does not require the QOF to separately improve the land upon which the building is located.⁷
      • During substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
5. Qualified Opportunity Zone Business
   

   A qualified opportunity zone business is a trade or business⁸:

   1. In which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property, determined by substituting “qualified opportunity zone business” for “qualified opportunity fund” in the definition of qualified opportunity zone business property;
      • The phrase “substantially all” in this requirement⁹is satisfied if at least 70% of the tangible property owned or leased by the trade or business is qualified opportunity zone business property.¹⁰
   2. At least 50% of the total gross income of such trade or business is derived from the active conduct of such trade business;
   3. A substantial portion of the intangible property of such trade or business is used in the active conduct of such trade or business; and
   4. Less than 5% of the average of the aggregate unadjusted bases of the property of such trade or business is attributable to nonqualified financial property¹¹.

Tax Treatment of Deferral

Capital gains that are deferred and invested pursuant to the Opportunity Zone Program are to be included in income on the earlier of:

• The date on which such investment is sold or exchanged; or
• December 31, 2026.¹²

The amount to be included in gross income after the deferral is the excess of:

• The lesser of (i) the amount of gain excluded or (ii) the fair market value of the investment over
• The taxpayer’s basis in the investment.¹³

As will be discussed below, the taxpayer’s basis in the investment(s) begins at zero.

Example:

Taxpayer A has $100 of eligible capital gains and elects to defer it pursuant to the Opportunity Zone Program on January 1, 2023. The $100 is properly invested in a QOF with a basis of zero. On December 31, 2026, Taxpayer A has not changed his position with respect to the investment, which is now worth $120. Taxpayer A must include $100 ($100 gain excluded – $0 basis) in income on December 31, 2026.

If on December 31, 2026, Taxpayer A has not changed his position with respect to the investment, but the investment is now worth $80, Taxpayer A would include $80 ($80 fair market value - $0 basis) in income.

Basis Adjustment for Investments

After properly deferring and investing eligible capital gains, the Opportunity Zone Program provides for an increase in basis in the investment after it is held for five, seven, and ten years.

The taxpayer’s basis in the investment begins at zero.¹⁴When the deferred gains are included in income in accordance with the procedure outlined in the previous section, the basis in the investment is increased by the amount of gain recognized.¹⁵After the investment is held for five years, the basis of such investment is increased by 10% of the gain deferred.¹⁶After seven years, the basis of such investment is increased by an additional 5% of the gain deferred.¹⁷Finally, after 10 years, the taxpayer may elect to increase the basis of such investment to its fair market value on the date such investment is sold or exchanged.¹⁸The following are several examples illustrating the application of these rules:

Example 1: Eligible Gains Reinvested in a QOF in 2023

Taxpayer A has $100 of eligible capital gains and elects to defer it pursuant to the Opportunity Zone Program in 2023. The $100 is properly invested in a QOF with a basis of zero. On December 31, 2026, Taxpayer A has not changed his position with respect to the investment, which is now worth $120. Taxpayer A must include $100 ($100 deferred gain – $0 basis) in income on December 31, 2026. Taxpayer A's basis in the investment is increased by $100 to $100.

On January 1, 2033, after 10 years, Taxpayer A sells the investment at its fair market value of $200 and elects a step-up in basis in accordance with 26 USC 1400Z-2(c). Taxpayer A's basis in the investment is stepped up to the amount realized ($200), and no gain is included in Taxpayer A's income from this transaction in 2033.

Example 2: Eligible Gains Reinvested in a QOF in 2019

Taxpayer A has $100 of eligible capital gains and elects to defer it pursuant to the Opportunity Zone Program in 2019. The $100 is properly invested in a QOF with a basis of zero. On December 31, 2026, Taxpayer A has not changed his position and has held the investment for at least 7 years. Accordingly, Taxpayer A is permitted to adjust his basis in the QOF by 15% of the amount of the deferred gain or $15. The investment is now worth $120. Taxpayer A must include $85 ($100 deferred gain - $15 basis) in income on December 31, 2026. Taxpayer A's basis in the investment is increased by $85 to $100.

Example 3: Eligible Gains Reinvested in a QOF in 2021

Taxpayer A has $100 of eligible capital gains and elects to defer it pursuant to the Opportunity Zone Program in 2021. The $100 is properly invested in a QOF with a basis of zero. On December 31, 2026, Taxpayer A has not changed his position and has held the investment for at least 5 years. Accordingly, Taxpayer A is permitted to adjust his basis in the QOF by 10% of the amount of the deferred gain or $10. The investment is now worth $120. Taxpayer A must include $90 ($100 deferred gain - $10 basis) in income on December 31, 2026. Taxpayer A's basis in the investment increased by $90 to $100.

On January 1, 2033, after 12 years, Taxpayer A sells the investment at its fair market value of $200 and elects a step-up in basis in accordance with 26 USC 1400Z-2(c). Taxpayer A's basis in the investment is stepped up to the amount realized ($200), and no gain is included in Taxpayer A's income from this transaction in 2033.

Implications for Investors and Developers

The Opportunity Zone Program offers many potential benefits for taxpayers; however, each taxpayer should analyze their own situation to determine how to best utilize the program.For example, due to the time period limitation on the deferral in the Opportunity Zone Program, an exchange under section 1031 of the Code may be preferable for investors in real estate as it allows the taxpayer to potentially defer gains until the death of the taxpayer (when heirs may elect for a stepped up basis in the assets).Additionally, in many energy projects that utilize tax-equity, there will not be an opportunity for a large, upfront investment of cash, so the tax-free treatment of the gains from the investment may be more important than the initial deferral and step-up in basis.

Footnotes