There’s a lot to break down in the Tax Cuts and Jobs Act of 2017 (TCJA), and many investors are still wrapping their heads around how they can benefit from many of the changes made. One intriguing and brand-new prospect that came with the TCJA is the opportunity zone. We’re going to dive in to what opportunity zones are, how you can benefit from investing in them and what else you need to know to get started.
What Is an Opportunity Zone?
Generally, opportunity zones are low-income census tracts, or areas adjoining low-income census tracts. They were nominated in 2018 by the governor of each state, district or U.S. territory and then certified by the Treasury. With approximately 8,700 zones approved, covering 12% of all U.S. territory, every major metropolitan area has at least one opportunity zone, and there are many located throughout rural areas as well.
As over 50 million people live in economically distressed areas, the purpose of an opportunity zone is to connect low-income communities with focused capital investments to promote economic growth. In 2017, U.S. households and corporations were sitting on an estimated $6.1 trillion in unrealized capital gains. The TCJA connects the two by allowing investors to take realized capitals gains and reinvest them into businesses in distressed communities across the country — in exchange for three big benefits.
Opportunity Zones Tax Benefits
If a capital gain is invested appropriately in a Qualified Opportunity Fund (QOF), there are three primary benefits:
- Tax Deferral: You can elect to defer the capital gain you invest until the earlier of December 31, 2026 or whenever you sell your qualified fund investment.
- Step-Up Benefits: You can get a step-up in the capital gain you are deferring if you invest long-term. If you hold the investment for five years, you get a 10% step-up. If you hold it for seven years, you get an additional 5% step-up, for 15% total. This means you could potentially not pay tax on 15% of the capital gain that you invested in a QOF.
- No Capital Gain Tax on Appreciation: If you hold the QOF investment for 10 years or more, there is no tax on the capital gain when you sell your QOF investment on any appreciation that has occurred from the initial time of the investment. This means that if you invest $1 million dollars today in a QOF and the investment is worth $3 million 10 years from now, then the $2 million increase is basically tax free.
Who Can Invest in Opportunity Zones?
The list of who can invest in opportunity zones is fairly extensive. It includes individuals, both C and S corporations, partnerships, LLCs, trusts and estates, common trust funds, qualified settlement funds and disputed ownership funds
To invest in a QOF, you must: have capital gain from an actual or deemed sale or exchange of property, or any other gain included in the calculation of capital gain for federal income tax purposes; the sale must be with an unrelated third party; and you must invest within 180 days of the transaction triggering the gain. The gain can be from personal, business or investment property.
What Qualifies as a Qualified Opportunity Fund?
Whether you’re looking for a QOF to invest in or you’d like to create one, there are restrictions around what qualifies as a QOF. For example, a fund can be a C or S corporation, a partnership or an LLC that is taxed as a corporation or partnership.
One big restriction is that the QOF must hold at least 90% of its assets in qualified opportunity zone property. Qualified opportunity zone property includes: qualified opportunity zone stock, qualified opportunity zone partnership interest and a direct investment by the fund into qualified opportunity zone business property. For the 90% test, the average percentage is measured semiannually, at the end of the fund’s first six months and again at year-end. The 90% test is based on amounts shown on the fund’s applicable financial statements (AFS) or cost if the QOF does not have AFS.
What counts as qualified opportunity zone business property itself comes with restrictions. The property needs be tangible property used in a trade or business of the QOF, and it must have been acquired by an unrelated party after December 31, 2017. Additionally, it either needs to be original use property, or there must have been substantial improvements made to the property (essentially the same amount paid to acquire the property is reinvested in the property to make improvements).
What Else You Need to Know About Opportunity Zones
Investors will see the three major benefits we discussed above without considering the risk. Is the QOF you’re interested in a good long-term investment? The QOF only has a certain amount of time to put your investment into business, property, improvements, etc. in order for that investment to be considered a qualifying asset. A lot of funds are being created, but they may not may not know how to spend the money they’re receiving in time.
At Wipfli, we perform many services for both investors and QOFs, including: QOF structuring and consulting, asset and income testing, attestation, auditing, compliance work, and even software technology implementations for startup QOFs.
But most of all, we are committed to educating clients about the intricacies of the rules around opportunity zones. This is new and exciting, and many clients are looking for help confirming whether an investment is in an opportunity zone and whether it qualifies, how to set up and structure a QOF if they’re looking to create one, and for help with both business and personal tax returns. We have both a great handle on current law and what we think the coming regulations will bring and are ready to have conversations with you around what is allowed currently and what you need to get started. Contact us to learn more.
"2018 Distressed Communities Index,” Economic Innovation Group, https://eig.org/dci, accessed February 2019.