Guide to Opportunity Zones: How Taxpayers Can Achieve Capital Gains Tax Benefits and Support Enterprise in Underserved Communities

Opportunity Zones are a compelling and powerful new tool for investors, asset owners, asset managers and communities that can mobilise capital for economic development in underserved communities, yielding good job creation, affordable and workforce housing development, community improvement and economic growth. Enacted as part of the Tax Cuts and Jobs Act of 2017 (the “Act”), Opportunity Zones are designed to:

  • Drive investment to designated underserved areas (Opportunity Zones)
  • By promoting the sale of capital assets and the reinvestment of capital gains proceeds
  • Through certified investment vehicles (Opportunity Funds)
  • Into qualified investments, including real estate (Opportunity Businesses)
  • While providing significant tax advantages to investors
  • And producing beneficial community development and Impact in the designated Opportunity Zones

A key aspect of the Opportunity Zone Program is that it enables taxpayers to defer and potentially reduce the recognition of capital gains on the sale of capital assets. To achieve these benefits, the taxpayer must reinvest the capital gain proceeds into a qualified Opportunity Fund within 180 days of the sale. Here are some specifics:

  • If a taxpayer holds its investment in the qualified Opportunity Fund for at least ten years, the taxpayer will receive a basis adjustment in an amount equal to the fair market value of the investment on the date the investment is sold or exchanged, enabling the taxpayer to exclude all gain on any appreciation of the Opportunity Fund during the investment period.
  • If a taxpayer holds the investment in the Opportunity Fund for five years, the taxpayer will receive abasis adjustment equal to 10% of the original deferred gain.
  • If a taxpayer holds the investment for seven years, the taxpayer will receive an additional basis adjustment equal to 5% of the original deferred gain.
  • In order to qualify for the full 15% basis adjustment, the taxpayer must make the investment in the Opportunity Fund before December 31, 2019 (i.e., seven years prior to the end of the deferral period under the Act, which occurs on December 31, 2016).
  • The original deferred gain from the sale of the capital asset, as adjusted by the foregoing applicable basis adjustments, must be recognised by the taxpayer when the taxpayer sells its interest in the Opportunity Fund or December 31, 2026, whichever occurs earlier.
  • The exclusion of capital gain taxes for investments in Opportunity Funds held for 10 years is only available to equity investments that are financed with rolled-over gain.
      • Example: If a taxpayer invests US$1,000,000 in an Opportunity Fund, but only US$600,000 of that investment is comprised of the capital gains generated by the sale of the taxpayer’s capital gain asset, then only 60% of the taxpayer’s equity investment in the Opportunity Fund is eligible for the applicable capital gains deferrals and exclusion. The amount of the exclusions remains dependent on the length of time the taxpayer holds the investment in the qualified Opportunity Fund.

It is anticipated that by the end of 2018, the Treasury Department will issue initial program guidance and clarification for the Opportunity Zone Program, with final guidance expected in 2019. We expect that this guidance will enable early movers to take advantage of the possibilities offered by Opportunity Zones in an intentional and impactful way.

Here are some questions that the Treasury Department guidance may address:

  • What is the required timeline for the Opportunity Fund to deploy new capital? The Act indicates that an Opportunity Fund may face penalties if 90% of its assets are not located in Opportunity Zones and that this 90% test is to be administered every six months. Does this regular six-month test suggest that the Opportunity Fund must deploy 90% of its capital within six months of fund formation?
  • Will an existing business, including existing real estate assets, located in an Opportunity Zone qualify as an eligible investment?
  • The IRS has indicated that the parties can self-certify as a qualified Opportunity Fund by completing a form that has not yet been released. Will this be the sole requirement for an Opportunity Fund to be certified?
  • The Act indicates that shares of stock in an Opportunity Business must be acquired at their “original issue,” whether directly or through an underwriter. Is this intended to merely exclude secondary market stock transactions, or does it mean that qualified stock may only be purchased in the first instance of an investment offering by a start-up company?
  • Will the “substantial improvement” test for existing real property assets be adjusted to better support the inclusion of certain types of properties that are traditionally subject to different programmatic improvement thresholds?
      • As enacted, the Act specifies that existing business property assets must be “substantially improved” within any 30-month period following acquisition of the property.
      • To be treated as “substantially improved,” the additions to the adjusted basis in the property must be equal to or greater than the adjusted basis of the property at the commencement of the 30-month period.
      • This “substantial improvement” test may be more onerous than the test applied to either Low-Income Housing Tax Credit properties (LIHTC) or New Markets Tax Credit properties (NMTC).
  • Without flexible interpretations of the “substantial improvement” test, Opportunity Funds may find it difficult to bring quality LIHTC or NMTC-eligible properties to market, therefore limiting the Impact generated by Opportunity Funds, which would not be consistent with the intent of the Act.

Despite the clarifications that the Treasury Department may provide, what we know for certain is that:

  • Opportunity Zones are currently designated, as reflected on this map prepared by the Economic Innovation Group1.
      • The Treasury Department has formally designated more than 8,700 low-income communities around the country as qualified Opportunity Zones.
      • These Opportunity Zone designations were made based upon eligible low-income community tracts that were determined based on the 2011-2015 American Community Survey 5-Year data from the Census Bureau. Certain designated community tracts that are not low-income but that are contiguous to low-income community tracts were also eligible for Opportunity Zone designation.
  • Investments must be made through qualified Opportunity Funds.
      • A qualified Opportunity Fund is an investment vehicle that holds (in the form of an equity investment and not debt) at least 90% of its assets in “Qualified Opportunity Zone Property” located in a qualified Opportunity Zone, including stock, partnership interests, business property.
      • An Opportunity Fund may be organised as a partnership or a corporation. (The anticipated Treasury Department guidance may provide clarification as to whether the term “corporation,” as used in the Act, includes a limited liability company.)
      • A qualified Opportunity Fund may be owned by one or more individuals, a small number of investors or by a large pool of investors (in the nature of a conventional fund) that is run by a professional fund manager.
      • Opportunity Zones are intended to incentivise taxpayers to exit from their existing capital gains-generating assets by rewarding them with tax incentives if they reinvest their gains into targeted low-income communities. The Act also facilitates the pooling of capital from multiple sources through the creation of the qualified Opportunity Funds and the potential scaling of investment capital in these underserved communities.
  • The potential capital gains deferrals and exclusions noted above can be achieved over time, with the largest breaks designed to encourage patient, long-term investment in the underserved communities that comprise the Opportunity Zones.
  • Investments in certain types of businesses are prohibited, including:
      • Massage parlors
      • Racetracks and other gambling establishments
      • Facilities whose primary business is the sale of alcohol for consumption off the premises

As the Opportunity Zone Program takes shape, we anticipate the following first movers:

  • Fund formation by fund managers intending to invest in:
      • Income-producing real estate (whether new construction or existing improvements that will be “substantially improved”) located within a qualified Opportunity Zone, including apartments, retail centers and office buildings.
      • High-growth startups, to be headquartered in qualified Opportunity Zones.
      • Impact-driven business opportunities located within qualified Opportunity Zones.

The Opportunity Zone program presents a significant potential for beneficial investment in designated low-income and traditionally underserved areas. First-movers, including fund managers, real estate investors, developers, and asset managers, are best positioned to take advantage of the tax and business benefits of the Act, while also achieving investment return and generating significant Impact within Opportunity Zones.

Though certain aspects of the Act’s implementation require clarification, it is important for anyone considering Opportunity Zone investments to evaluate various approaches and options, including alternative investment structures well-suited to revenue-based, long-term holdings, in order to maximise the financial, tax, and Impact benefits presented by the Opportunity Zone program.