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Tuesday, June 4, 2019

Opportunity Zones Equal Significant Tax Benefits


Akin to the combined tax benefit of a 401(k) and a Roth IRA, an investment in one of the country’s 8,700 designated opportunity zones has the potential to be one of the most significant tax-benefited investments in the history of the U.S. tax code.

The Tax Cuts and Jobs Act added sections 1400Z-1 and 1400Z-2, which seek to encourage economic growth and investment in designated distressed communities (qualified opportunity zones) by providing Federal income tax benefits to taxpayers who invest new capital in businesses located within qualified opportunity zones through a QOF (qualified opportunity fund).

There are two main tax incentives encouraging investment in qualified opportunity zones. The first incentive is a deferral of inclusion in gross income of certain gain to the extent that a taxpayer elects to invest a corresponding amount in a QOF. The second incentive allows for the taxpayer to elect to exclude from gross income the post-acquisition gain on investments in the QOF held for at least 10 years. Additionally, with respect to the deferral of inclusion in gross income of certain gain invested in a QOF, section 1400Z-2 permanently excludes a portion of such deferred gain if the corresponding investment in the QOF is held for five or seven years.

Thus, this one-two combo of incentives is similar to both a 401(k) and Roth IRA, and in most cases, with a much shorter holding period.


Definitions

QO Zone

A qualified opportunity zone (“QO”) is a population census tract that is a low-income community. Notice 2018-48 lists the 8,700 population census tracts the Secretary of the Treasury designates as qualified opportunity zones.

QO Fund

A qualified opportunity fund (“QOF”) is an investment vehicle organized as a domestic corporation or a partnership for the purpose of investing in qualified opportunity zone property. A QOF must hold at least 90% of its assets in qualified opportunity zone property.

The 90% investment standard is determined by the average of the percentage of qualified opportunity zone property held in the QOF as measured on:

  1. The last day of the first 6-month period of the tax year of the QOF, and
  2. The last day of the tax year of the QOF.

QO Zone Property

Qualified opportunity zone property includes qualified opportunity zone stock, a qualified opportunity zone partnership interest and qualified opportunity zone business property.

QO Zone Stock

Qualified opportunity zone stock is any stock of a domestic corporation that a QOF acquires after 2017. The corporation must be a qualified opportunity zone business (defined below) when the stock is purchased. The corporation must be organized for the purpose of being a qualified opportunity zone business. The corporation must qualify as a qualified opportunity zone business for substantially all of the time the QOF holds the stock.

QO Zone Partnership Interest

Qualified opportunity zone partnership interest is any capital or profits interest in a domestic partnership that a QOF acquires after 2017 in exchange for cash. The partnership must be a qualified opportunity zone business when the QOF acquires the interest. The partnership must be organized for the purpose of being a qualified opportunity zone business. The partnership must qualify as a qualified opportunity zone business for substantially all of the time the QOF holds the interest.

QO Zone Business Property

Qualified opportunity zone business property is tangible property that a QOF acquires after 2017 and uses in a trade or business and that satisfies both of the following tests:

  1. The use of the property in the qualified opportunity zone originates with the QOF, or the QOF substantially improves the property.
  2. During substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.

To satisfy the test in (1) above, the QOF substantially improves property if, during any 30-month period beginning after the date of the acquisition of such property, additions to basis with respect to such property in the hands of the QOF are more than an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF.

QO Zone Business

A qualified opportunity zone business is a trade or business if substantially all of its owned or leased tangible property is qualified opportunity zone business property, defined above, and if the trade or business satisfies all of the following tests:

  1. The business generates at least 50% of its total gross income from the active conduct of a qualifying trade or business.
  2. The business uses a substantial part of its intangible property in the active conduct of any such business.
  3. Less than 5% of the average of the total unadjusted basis of the property of the business is from nonqualified financial property.
  4. The business is not 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 the principal business of which is the sale of alcoholic beverages for consumption off premises.

In Detail (with Example)

Temporary Deferral of Gain

A gain on property that is sold to an unrelated person can be deferred for any portion of the gain that is invested in a QOF within 180 days. There’s no dollar limitation on the amount of gain that can be deferred under this rule, but the election applies only to capital gains reinvested in a QOF.

Gain that’s excluded under the temporary deferral election is included in income in the tax year in which the investment in the QOF is sold or exchanged, or by December 31, 2026 — whichever is earlier. The amount included in income is the lesser of the amount of gain excluded under the election, or the fair market value of investment. That amount is then decreased by the tax basis in the investment — which is generally zero.

If an investment is held for at least five years, then its basis is increased by an amount equal to 10% of the gain temporarily deferred. That basis is increased by an additional 5% of the gain deferred if the investment is held for at least seven years, and if the investment is held until at least December 31, 2026, the basis is increased by the remaining 85% of deferred gain.

A temporary gain deferral election cannot be made for a sale or exchange if an election previously made with respect to the sale or exchange is in effect. A second reinvestment in a QOF of any gains from the same sale or exchange does not qualify for the election, and an election can’t be made for any sale or exchange completed after 2026.

Permanent Deferral of Gain

If a QOF is held for at least 10 years, post-acquisition capital gains can be permanently excluded upon disposition of the investment. This is done through increasing the investment’s basis to its fair market value on the date the investment is sold or exchanged. Permanent deferral election does not prevent the recognition of gain that was deferred under the temporary gain deferral election.

Since it is not possible to hold the investment for 10 years prior to December 31, 2026, the permanent exclusion election only excludes gain in excess of the deferred gain (i.e., only post-acquisition gains are excluded).

Example

In 2019, you sell for $11,000,000 publicly traded stock that you originally purchased for $1,000,000. Your capital gain amount is $10,000,000, but within 180 days of the trade date, you reinvest the $10,000,000 gain amount in a QOF in 2019.

If you hold the QOF for five years and sell in 2024 for $15,000,000, you include in 2024 taxable income $9,000,000 of the original $10,000,000 of capital gain from the 2019 sale, and $5,000,000 of gain from the sale of the QOF investment.

If the QOF is held for seven years and sold in 2026 for $17,000,000, you include in 2026 taxable income $8,500,000 of the original $10,000,000 of capital gain from the 2019 sale, and $7,000,000 of gain from the sale of the QOF investment.

If you hold the QOF for 10 years and sell in 2029 for $20,000,000, you would have already included $8,500,000 of the original $10,000,000 capital gain in your 2026 taxable income, so no gain is reported upon sale of the QOF investment in 2029, leaving you with an overall exclusion of taxable gain in the amount of $11,500,000!

Opportunity Zone State Issues

When choosing an investment within the 8,700 census tracts and various specific QOFs, state tax planning becomes very important. As only about half of the states have conformed to sections 1400Z-1 and 1400Z-2, taxpayers may still incur a tax liability in their home state and potentially in other states if the QOF makes national investments.

How Can We Help?

Armanino can provide the necessary expertise to assist you in QOF selection and/or formation, annual tax compliance and the eventual liquidation of your QOF investment. Reach out to Nick Gibbons or Alex Thacher to get started.

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