Tax reform is dramatically changing real estate investment, creating a number of opportunities. For example, over the next ten years, private investors will be eligible for certain tax benefits in return for investing in specific low-income communities called “Opportunity Zones.”
Opportunity Zones are a new community development program established by Congress in the Tax Cuts and Jobs Act (TCJA) in order to spur investment in distressed communities throughout the country. In general, the program provides a tax incentive for investors to re-invest their unrealized capital gains into Opportunity Funds that are dedicated to investing into these Opportunity Zones. In the spring of 2018, the Treasury Department and IRS announced the designation of "Opportunity Zones" in 18 states. For a complete list, click here.
How Does the Program Work?
Investors can defer tax on capital gains invested in a Qualified Opportunity Fund (QOF - 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) 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%. 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. Note: You can take advantage of 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.
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. The return with Form 8996 must be filed timely, taking extensions into account.
What are the Key Takeaways?
All types of capital gains – but only capital gains (i.e. not ordinary gains) – are eligible for the tax benefit.
A partnership may elect to defer part or all of a capital gain. That deferred gain will not be included in the distributive shares of the partners.
Qualified Opportunity Funds
Opportunity Funds must be classified as a corporation or partnership for income tax purposes, meaning a limited liability company (LLC) can qualify. They must also be created or organized in one of the 50 U.S. states, DC, or a U.S. territory.
Pre-existing entities can qualify as Opportunity Funds or Opportunity Zone businesses as long as they satisfy the necessary requirements.
Opportunity Funds will be able to choose the first month in which they are treated as an Opportunity Fund. The last day of the fund’s taxable year is a test date for the 90-percent asset test.
An Opportunity Fund must value its assets for purposes of the 90-percent asset test using values reported on the fund’s audited or filed financial statements (or using the cost of the assets if it does not have them).
Though Opportunity Zone designations expire at the end of 2028, taxpayers may continue to hold Opportunity Fund interests invested in those zones and still may step up the basis of their Opportunity Fund investments to fair market value if they hold the investments for ten years.
For Opportunity Zone Businesses
At least 50 percent of gross income must be derived from the active conduct of a trade or business within an Opportunity Zone. Likewise, a substantial portion of intangible property must be used in the active conduct of a trade or business within an Opportunity Zone.
For purposes of determining whether “substantially all” of a business’s tangible property is Opportunity Zone business property, the proposed rules define “substantially all” to mean 70 percent or more.
The U.S. Treasury proposes that cash and cash equivalents designated as working capital will not be counted as “nonqualified financial property” for up to 31 months if certain conditions are met, including a written plan on how the working capital will be used to invest in Opportunity Zone property.
Property subject to construction or substantial improvement in accordance with the working capital plan will not fail to qualify as Opportunity Zone business property solely because the planned expenditures have not been completed (and thus can contribute to meeting the 70 percent “substantially all” test if it otherwise meets the definition of Opportunity Zone business property).
Pursuant to an IRS revenue ruling, for purposes of determining whether an existing building on land in a zone has been substantially improved, the improvements need to double the owner’s basis in the building only - not in the land. The Treasury Department intended this, in part, to encourage the repurposing of vacant buildings in Opportunity Zones.
Many key questions remain unanswered and additional rounds of rulemaking are yet to come. Stakeholders have until December 28, 2018 to submit comments on the proposed regulations, and the U.S Department of Treasury and the IRS intend to hold a public hearing on January 10, 2019. If you are interested in investing in a Qualified Opportunity Fund or you are a business in a designated Opportunity Zone that seeks to take advantage of the Program, please contact Restivo Monacelli.