After a 10-year U.S. economic expansion, taxpayers hold trillions of dollars in unrealized capital gains.
To encourage investment in economically depressed areas, the U.S. Tax Cut and Jobs Act of 2017 created a program that allows investors to essentially “roll” what would otherwise be taxable capital gains into investments into Opportunity Zones (OZ).
These zones were nominated by state governors in low-income areas determined from community census tracts and there are now about 8,700 around the country.
The Mahoning Valley contains 15, about which The Business Journal has already written. New U.S Treasury Department regulations have clarified a number of issues concerning Opportunity Zones.
An investment in an OZ must be made through a Qualified Opportunity Fund (QOF).
A QOF is an investment vehicle (partnership, corporation or LLC), 90% of whose assets hold OZ property, which can be:
• An equity interest in an OZ business.
• A real estate investment.
• An interest in an OZ business property, which is:
– Tangible property used in the business.
– Acquired after Dec. 13, 2017.
– Substantially all of which is used in the OZ.
After passage of the Tax Cut and Jobs Act, a large number of “blind pool” funds were raised geared toward making real estate investments, although single purpose funds seem to be becoming more popular.
With real estate, investment is seen both in new development and in rehabilitation projects.
With a rehab project, QOF funds must be spent within 30 months on a “substantial improvement.”
A commitment to a project is not enough. There must be a real plan and actual expenditures.
Almost any business can be conducted in the OZ, except “sinful” ones.
Thus, a massage parlor or liquor store may not work, while a restaurant serving liquor certainly would.
Investors have 180 days to roll their capital gains into a Qualified Opportunity Fund.
Unlike the requirements for tax deferral of real estate gains under Code Section 1031, there is no requirement that an investor work through a qualified intermediary or look for a “like-kind” investment.
Gain on the sale of any capital asset is eligible to roll into a Qualified Opportunity Fund.
Here are the tax incentives:
• The temporary deferral of capital gains invested into a QOF until the earlier of a sale of the QOF investment, or Dec. 31, 2026.
• A step-up in tax basis as follows:
– If the taxpayer holds less than five years, no more than 90% of capital gains is included in income.
– If the taxpayer holds more than seven years, no more than 85% included in income.
– If taxpayer holds more than 10 years, all gains accrued on the Qualified Opportunity Fund investment are tax-free.
Other points to consider:
• Code Section 1231 gains are netted.
• Gains are determined as of Dec. 31 and the 180-day period begins to run then.
• Single-member LLCs are not eligible.
• Only capital gains qualify (there is no ordinary income deferral).
• “Pass-through” entities such as Sub-S corporations, partnership or LLCs can be used.
• Property can be contributed to a QOF, instead of cash.
• Transfers on death of a QOF do not cause tax recognition.
• Transfers to a revocable trust do not cause recognition.
• One cannot buy raw land and qualify, unless there is a bona fide plan to develop it.
• Leases can qualify, but there are special rules for related party transactions.
• A Qualified Opportunity Fund business must earn at least 50% of its gross income from activities within the zone.
In sum, some would say that the economic expansion is getting long in the tooth.
A taxpayer, for instance, with substantial long-term stock market gains may consider selling and locking in gains and then investing within 180 days in a Qualified Opportunity Fund or Funds.
This will postpone tax recognition until the fund is sold or 2026 (the earlier) and may afford a 10% or 15% reduction in the ultimate tax rate.