The Tax Cuts and Jobs Act of 2017 created the Opportunity Zone program to encourage investments in certain distressed communities through tax benefits.
A qualified opportunity zone (QOZ) is a population census tract signifying a low-income community nominated by the local government (via collaboration with the federal government). Investments made within the QOZ have the ability to gain tax benefits.
How Opportunity Zones Work
A taxpayer with eligible capital gains can elect to defer any associated tax liability by timely investing into a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle organized as a corporation or partnership to invest in QOZ property. The QOF must hold at least 90% of its assets in QOZ property or it will be subject to penalties.
The QOF investment must be made within 180 days of the date of the sale or exchange generating qualified capital gains (with special rules for gain reported on a schedule K-1 and gain from an installment sale) and may provide an alternative to a Section 1031 tax deferred exchange. Recognition of the capital gain is deferred until the earlier of:
- The sale or exchange of the QOF investment
- December 31, 2026
Note: as a result, any deferred gain will be reported no later than 2026, even if the QOF investment is still owned after 2026.
Other tax benefits include:
- For investments made by the end of 2019, if the QOF investment is held at least seven years, the original gain amount is reduced by 15%
- For investments made by the end of 2021, if the QOF investment is held at least five years, the original gain amount is reduced by 10%
- If the QOF investment is held for at least 10 years and all other requirements are met, any gain from the sale of the QOF investment or gain from the sale of underlying assets can be excluded from taxable income. Included in this gain exclusion is depreciation recapture.
Operating profits during the life of the QOF, though, are taxed just like any other business.
Acquiring and Investing in Qualified Opportunity Zone Business Property and Qualified Opportunity Zone Businesses
90% of a QOF’s assets must be composed of Qualified Opportunity Zone Business Property (QOZBP) or interests in one or more Qualified Opportunity Zone Businesses (QOZBs). The QOF self-certifies as a QOF by completing IRS Form 8996, and it uses this form for measuring the 90% asset test on the last day of the first six months of a QOF’s tax year and the last day of the QOF’s tax year. Failing to meet this 90% test can result in penalties.
The existing rules favor a tiered structure, where the QOF owns the majority of a QOZB entity (normally a partnership for tax purposes). Generally, this is because a QOZB entity can make use of a “working capital safe harbor” whereby working capital is deemed to be a “good asset” for up to 31 months. Note: there are specific regulatory requirements for relying upon this working capital safe harbor. Without this working capital safe harbor, an OZ investment holding cash (even if it is for future development) can be subject to penalties.
Although real estate is the dominant investment activity for most QOFs, the rules do contemplate a QOF and/or QOZB conducing a non-real estate business. There is a 50% gross income requirement, and there are three safe harbors, plus a “facts and circumstances” alternative, for purposes of determining whether 50% or more of gross income is derived by a QOZB through the active conduct of a trade or business within an opportunity zone.
While generally acknowledging that the ownership and leasing of real property can be “active conduct of a trade or business,” the regulations provide that merely entering into a triple-net lease is not a trade or business. Consequently, real estate leasing activities in a QOF or through a QOZB will require careful planning.
COVID Extensions for the Opportunity Zone Program
In response to the COVID pandemic, the government released guidance (Notice 2021-10) providing certain relief for opportunity zone investors. This relief comes in the form of extended deadlines and the relaxation of rules for certain provisions of the Opportunity Zone program, including an extension of the working capital safe harbor plan timeline by up to an additional 24 months.
How Opportunity Zones Can Help You
A properly structured opportunity zone investment can allow investors to defer current year tax liabilities and to exit a business deal after 10 years without any associated tax liabilities (other than the deferred gain being due in 2026). Due to these powerful tax incentives, many taxpayers continue to focus on investing into Opportunity Zones.
Opportunity Zone Funds are a beneficial strategy for businesses.
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