New Tax Deferral Possibility by Investing in Qualified Opportunity Zone

Public Law 115-97, more commonly known as The Tax Cuts and Jobs Act, added Sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code (the “Code”). Sections 1400Z-1 and 1400Z-2 allow a taxpayer to defer paying taxes on capital gains by investing such capital gains in a Qualified Opportunity Fund (“Opportunity Fund”) holding certain property in a Qualified Opportunity Zone (“Opportunity Zone”). The Opportunity Zone program should encourage investment in low-income communities.

An Opportunity Zone is a nominated population census tract that is considered a low-income community. Under Section 45D of the Code, a low-income community includes any population census tract with a poverty rate of at least 20%. The governor of each state can nominate up to 25% of the low-income communities within the state as Opportunity Zones. In June, the Department of the Treasury and the Internal Revenue Service finalized the list of Opportunity Zones. Opportunity Zones are located in all 50 states, the District of Columbia, and five United States territories. In Florida, Governor Rick Scott designated 427 communities as Opportunity Zones, including 26 communities in Palm Beach County. The Opportunity Zone designation remains effective until December 31, 2028.

A taxpayer invests in an Opportunity Zone by purchasing an interest in an Opportunity Fund. An Opportunity Fund is an investment vehicle organized as a corporation or a partnership that holds at least 90% of its assets in qualified opportunity zone property (defined below) located in an Opportunity Zone. Under Section 1400Z-2(d)(1), this 90 percent threshold is determined by averaging the percentage of qualified opportunity zone property held in the Opportunity Fund as measured on the last day of the first 6-month period of the taxable year of the Opportunity Fund, and on the last day of the taxable year of the Opportunity Fund. If the Opportunity Fund does not meet the 90 percent threshold, Section 1400Z-2(f)(1) states that the Opportunity Fund must pay a penalty for each month it fails to meet the 90 percent threshold in an amount equal to the product of the excess of the amount equal to 90 percent of its aggregate assets, over the aggregate amount of qualified opportunity zone property held by the Opportunity Fund, multiplied by the underpayment rate established under Section 6621(a)(2) for such month. For any Opportunity Fund organized as a partnership, it appears that each partner must pay a proportionate share of this penalty.

An Opportunity Fund must invest in qualified opportunity zone property. Under Section 1400Z-2(d)(2), qualified opportunity zone property includes qualified opportunity zone business property, qualified opportunity zone stock, and a qualified opportunity zone partnership interest. However, an Opportunity Fund cannot invest in another Opportunity Fund. Section 1400Z-2(d)(2)(D) discusses the requirements of qualified opportunity zone business property (“Opportunity Zone Property”). First, Opportunity Zone Property can be any tangible property used in a trade or business of the Opportunity Fund if the property was acquired by the Opportunity Fund by purchase (as defined in Section 179(d)(2) of the Code) after December 31, 2017. Next, the original use of such property must commence with the Opportunity Fund or the Opportunity Fund must substantially improve the property. Under Section 1400Z-2(d)(2)(D)(ii), property is substantially improved only if “during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.” Finally, substantially all of the use of the Opportunity Zone Property must be in an Opportunity Zone during substantially all of the time the Opportunity Fund holds such Opportunity Zone Property.

Section 1400Z-2(d)(2)(B) and (C) define qualified opportunity zone stock and qualified opportunity zone partnership interest. The definitions are substantially similar. Qualified opportunity zone stock is any stock in a domestic corporation operating as a qualified opportunity zone business if such stock was acquired by the Opportunity Fund after December 31, 2017 at its original issue (directly or through an underwriter) from the corporation solely in exchange for cash. A qualified opportunity zone partnership interest is any capital or profits interest in a domestic partnership operating as a qualified opportunity zone business if such interest was acquired by the Opportunity Fund after December 31, 2017 from the partnership solely in exchange for cash. At the time the qualified opportunity zone stock (or partnership interest) is acquired and during substantially all of the Opportunity Fund’s holding period of such stock (or partnership interest), the corporation (or partnership) must operate as a qualified opportunity zone business. If a corporation (or partnership) is a new entity, such entity must be organized as a qualified opportunity zone business.

Section 1400Z-2(d)(3) lists the requirements of a qualified opportunity zone business. First, substantially all of the tangible property owned or leased by the entity must be Opportunity Zone Property. A qualified opportunity zone business must also generate at least 50 percent of its total gross income from the active conduct of its business and a substantial portion of its intangible property must be used in the active conduct of its business. Furthermore, less than five percent of the average of such business’s aggregate unadjusted property bases may be attributable to nonqualified financial property. Most trades or businesses can be a qualified opportunity zone business. However, a qualified opportunity zone business does not include a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store whose principal business is the sale of alcoholic beverages for consumption off premises.

If a taxpayer realizes a capital gain on the sale or exchange of any capital asset to any unrelated person, the taxpayer can defer the gain recognition event by investing the proceeds in an Opportunity Fund. A taxpayer can defer capital gains up to the amount of the capital gains proceeds invested in an Opportunity Fund. A taxpayer must invest in an Opportunity Fund within 180 days from date of the sale or exchange of the capital asset. The taxpayer who sold the capital asset must be the taxpayer investing in the Opportunity Fund. However, when a partnership or S corporation is the taxpayer selling the capital asset, Sections 1400Z-1 and 1400Z-2 do not clarify whether only the entity itself can invest in an Opportunity Fund.

Under Section 1400Z-2(b), the deferred capital gains will be recognized at the earlier of December 31, 2026 or the date on which the investment in the Opportunity Fund is sold or exchanged. The deferred gain will be taxed at the rate in effect for the year in which the gain is recognized. Although a taxpayer can hold an Opportunity Fund interest after December 31, 2026, the taxpayer must recognize any deferred gain on that date, which creates a phantom income issue. Except as provided below, the taxpayer’s basis in an Opportunity Fund interest will be zero. A taxpayer can increase their basis by holding the Opportunity Fund interest for at least five years. If a taxpayer holds the Opportunity Fund interest for five years, the taxpayer receives a basis increase from zero to 10% of the deferred gain invested in the Opportunity Fund. Thus, 10% of the deferred gain will be permanently forgiven upon the sale of the Opportunity Fund interest. If a taxpayer holds the Opportunity Fund interest for seven years, the taxpayer receives a basis increase in the Opportunity Fund interest equal to 15% of the deferred gain invested in the Opportunity Fund. A taxpayer must invest in an Opportunity Fund by 2019 in order to take advantage of the 15% basis increase.

If a taxpayer holds the Opportunity Fund interest for ten years, Section 1400Z-2(c) provides that the taxpayer will be eligible for a basis increase equal to the fair market value of the investment on the date that the investment is sold or exchanged. The complete basis step-up can only be obtained if the taxpayer holds the interest in the Opportunity Fund through December 31, 2026. Although the taxpayer must recognize the deferred gain (as phantom income) on December 31, 2026, it appears the taxpayer will not be taxed on any further appreciation in the Opportunity Fund interest upon the ultimate sale of such interest.

The new Opportunity Zone program allows a taxpayer to receive preferential tax treatment in exchange for investing in a Qualified Opportunity Fund. A taxpayer can defer paying taxes on capital gains and potentially wipe out any future appreciation on the Qualified Fund interest if the taxpayer holds the interest for ten years. Due to the aforementioned tax benefits, the Opportunity Zone program should encourage investment in low-income communities.