Opportunity Zones Could Spur Private Investment in Low Income Areas
The latest tax reform passed in the Tax Cuts and Jobs Act (TCJA) created a new incentive which will impact real estate development in low-income communities by creating “Qualified Opportunity Zones.”[1] The impact of these Qualified Opportunity Zones will be felt by municipalities, businesses and investors.
Impact on Municipalities
Under this new law, the Governor will nominate roughly 500 population census tracts as Qualified Opportunity Zones. These census tracts must either be located within a “low income community”[2] or be contiguous with a low income community. If the nominated census tract is contiguous with a low income community, the median family income in the census tract can be no more than 125% the median family income in the low income community. The governor is limited in the number of census tracts he can nominate, with the number of nominations being limited to 25% of all low income communities in the state and only 5% of these nominations can be census tracts contiguous with low income communities. With over 2,000 eligible census tracts in New York state, this will undoubtedly create a great deal of lobbying and politicking from local municipalities across the state in effort to get their low income communities nominated as a Qualified Opportunity Zones.
Communities that are designated as Qualified Opportunity Zones will benefit from the requirement that 90% of the assets in a “Qualified Opportunity Fund”[3] must be invested in “Qualified Opportunity Zone Property,”[4]which includes businesses and properties located in Qualified Opportunity Zones. As a result, this program should inject some much needed capital into low income communities. The nomination process will be handled by Empire State Development and its regional offices. The governor must make nominations for Qualified Opportunity Zones by April 20, 2018 and local regional economic development councils will make their recommendations of census tracts to the governor on March 30, 2018.
Impact on Businesses
At least 90% of the assets in a Qualified Opportunity Fund must be Qualified Opportunity Property. Qualified Opportunity Property includes stock, partnership interests and tangible property of Qualified Opportunity Zone Businesses. A business will qualify as a Qualified Opportunity Zone Business if substantially all of its tangible property, either owned or leased, is Qualified Opportunity Zone Business Property[5] and the business meets the statutory requirements of a Qualified Opportunity Zone Business. Qualified Opportunity Zone Business property either owned by a Qualified Opportunity Fund or a Qualified Opportunity Zone Business must be improved after it is purchased, either for a use unique to the business or fund or, if the use is to remain the same as it was before the property was purchased, the business or fund must make additions to the property, which result in an increase in the owner’s basis greater than the adjusted basis when the property was purchased. This will ensure that Qualified Opportunity Funds and businesses are using the new investments to improve these low income communities.
This asset requirement should spark strong investments by Qualified Opportunity Funds in corporations and domestic partnerships that qualify as Qualified Opportunity Zone Businesses. This will incentivize businesses to grow and develop real estate in these Qualified Opportunity Zones in order to qualify for these investments. As discussed later in this article, the Qualified Opportunity Funds should see substantial investments from both individuals and corporations because of the capital gains savings for investing in these Qualified Opportunity Funds.
Impact on Investors
Investors who sell or exchange property to an unrelated party can defer a payment of capital gains on such a sale or exchange if the capital gains are invested in a Qualified Opportunity Fund within 180 days of the transaction.[6] When the investment is first made the investor’s basis will be zero. However, if the investment is maintained in the Qualified Opportunity Fund for 5 years, the investor’s basis will increase by 10% of the capital gains which were deferred. If the investment is kept in the Qualified Opportunity Fund for an additional two years, 7 years total, the basis will increase by another 5% of the original capital gains which were deferred. There will be a recognition event, resulting in capital gains to the investor on the first of the following dates: (1) the date the investment is sold or liquidated or (ii) December 31, 2026.[7] When this recognition event occurs, the capital gains will be owed by the investor in an amount equal to the amount deferred by the original investment reduced by any basis earned for keeping the investment in the Qualified Opportunity Fund for 5 and/or 7 years.[8] If after recognizing the capital gains, reduced by any basis gained, an investor keeps the investment in the Qualified Opportunity Fund for 10 years or longer, the investor will not recognize any additional capital gains if it decides to sell or exchange its investment. If an investment is kept in a Qualified Opportunity Fund for 10 or more years, the basis for that investment becomes the fair market value of the investment on the day the investment is sold or exchanged. This means that an investor can defer payment of any capital gains until the recognition event, pay a reduced amount of capital gains on the recognition event, and continue to profit from this investment without any additional tax liability if the investment is maintained for 10 or more years in the Qualified Opportunity Fund.
An example of the capital gains deferment and savings can be found below:
If an investor has $40 million in capital gains from a sale, the investor can defer recognition of the $40 million in capital gains if the $40 million is invested in a Qualified Opportunity Fund within 180 days of the sale. When the investment is made, the basis will be $0. However, if the investment is maintained in the Qualified Opportunity Fund for 5 years, the investment will receive an increase of its basis equal to $4 million (10% of the original investment). If the investment is maintained for an additional 2 years, the investment’s basis will increase to $6 million (15% of the original investment). On the recognition event, the investor will recognize capital gains on $34 million, instead of the original $40 million. If the investment is maintained for 10 or more years, the basis of the investment becomes its fair market value on the day it is sold. If the investment has grown over the 10 years it was maintained in the Fund, say to $50 million, the investor will not recognize any additional capital gains when the investment is sold. When the investment is sold for $50 million after 10 years, the investor would have only recognized capital gains on $34 million of the investment (the amount paid on the recognition event).
This capital gains deferment and adjusted basis for long term investments should attract many investors who are seeking to defer and reduce any capital gains it may incur from a sale and are seeking to avoid incurring capital gains on long term investments. This incentive should create a large fund for financing Qualified Opportunity Zone Businesses looking to develop projects in low income communities.
The Treasury Secretary is granted with the authority to create necessary or appropriate regulations for these Qualified Opportunity Zone programs. Once such regulations are enacted, an updated legal alert outlining the effect of any future regulations will be provided.
[1] 26 U.S.C. § 1400Z-1(a).
[2] As defined in 26 U.S.C. § 45D(e); see 26 U.S.C. § 1400Z-1(c)(1).
[3] As defined in 26 U.S.C. § 1400Z-2(d).
[4] As defined in 26 U.S.C. § 1400Z-2(d)(2).
[5] Qualified Opportunity Zone Business Property is defined as: (i) property that was acquired by the Qualified Opportunity Zone Business after 12/31/2017; (ii) the property’s original use began with the purchase by the Qualified Opportunity Zone Business or it substantially improved the property; and (iii) during the Qualified Opportunity Zone Business’ holding of the property, substantially all of the property’s use was within a Qualified Opportunity Zone. 26 U.S.C. § 1400Z-2(d)(3)(A)(i).
[6] 26 U.S.C. § 1400Z-2(a)(1).
[7] 26 U.S.C. § 1400Z-2(b)(1).
[8] 26 U.S.C. § 1400Z-2(b)(2)(A).