Opportunity
Zones are among the hottest of Hot
Topics in real estate investment today. With
the December 22, 2017 enactment of the Tax Cuts and Jobs Act that added Section
1400Z to the Internal Revenue Code, Opportunity Zones were authorized as a potentially
powerful tax deferral and tax exclusion incentive to develop predominantly low-income
communities. The tax issues related to Opportunity Zone investment are
multilayered and complex, but the essential tax benefits are reasonably
straightforward and easy to understand. The potential tax benefits of
investment in Opportunity Zones are serving as an exciting foundation for investment
in community redevelopment. Opportunity Zones are not, however, the tax and
investment panacea some imagine.
STATUTORY AUTHORIZATION
Authorization
to create Qualified Opportunity Zones was set forth in new IRC Section 1400Z-1.
Special rules for treatment of capital gains invested in Qualified Opportunity
Zones are set forth in Section 1400Z-2.
DESIGNATION OF OPPORTUNITY ZONES
As
of December 2018, all Qualified Opportunity Zones have been designated. Each
Opportunity Zone corresponds to a Census Tract meeting certain low-income
guidelines. There is currently no mechanism to create any additional Qualified Opportunity
Zones or to expand or modify any existing Qualified Opportunity Zone. Various mapping tools are available online to
enable you to locate Qualified Opportunity Zones and to determine whether any
specific property is located within a Qualified Opportunity Zone and therefore
eligible for the special tax treatment authorized by IRC 1400Z-2.
THREE KEY TAX BENEFITS OF OPPORTUNITY ZONE INVESTMENT
The
three principal tax benefits of investment in a Qualified Opportunity Zone,
assuming the technical rules required by IRC 1400Z-2 and the implementing regulations
are satisfied, are as follows:
- Tax
Deferral. Tax on capital gain reinvested in a Qualified
Opportunity Zone is deferred until December 31, 2026 (unless the investment is
sold or exchanged prior to that time). See: IRC §1400Z-2 (B). The capital gain
subject to deferral is not limited to just capital gains from the sale of real
estate, but also includes other capital gains, including those derived from the
sale of stock and partnership interests as well.
- Partial
Exclusion of Deferred Gain; 5 Year and 7 Year Holding Periods.
A portion of the deferred gain reinvested in a Qualified Opportunity Zone for five
years or seven years is excluded from taxation by increasing the tax basis of
the investment by a percentage of the reinvested gain. In the case of an
investment held for at least five (5) years, the tax basis of the investment is
increased by an amount equal to ten percent (10%) of the amount of the deferred
gain. In the case of an investment held for at least seven (7) years, the tax basis
of the investment is increased by an amount equal to an additional five percent
(5%) of the amount of the deferred gain, with the result that after seven (7) years
of gain deferral the basis of the property will have increased by an aggregate
of fifteen percent (15%) of the deferred gain. Since the recognition date for
deferred gain is December 31, 2026 pursuant to IRC §1400Z-2(B), as referred to above,
in order to receive the maximum tax benefit the gain must be reinvested in a
Qualified Opportunity Zone on or before December 31, 2019 (seven years before
December 31, 2026). But still, the tax benefits for the five (5) year holding period
remains available for investments made through December 31, 2021. See: IRC §1400Z-2(B).
- Stepped-Up
Basis For Post-Investment Gain; 10 Year Holding Period.
Perhaps the most powerful incentive is the special rule for investments held
for at least ten (10) years. Pursuant to IRC §1400Z-2(C), in the case of a
qualifying investment in a Qualified Opportunity Zone held by the taxpayer for
at least 10 years, upon election by the taxpayer the basis of the investment
will be stepped-up to its fair market value as of the date the investment is
sold or exchanged. The effect of this provision is to exclude all appreciation
in the investment from taxation (although it should be noted that the taxpayer
would have been obligated to recognize and pay tax on 85% of the initially deferred
gain (7-year holding period) or 90% of the initially deferred gain (5-year
holding period) as of December 31, 2026).
If there has been substantial appreciation during the holding period of
ten or more years, no tax on that gain will be owed if the taxpayer elects to
have the tax basis stepped-up to the fair market value of the investment as of
the date it is sold or exchanged. See: IRC §1400Z-2(C).
EXAMPLE: Suppose QOZ investor sells an asset and realizes a capital gain of $500,000 on October 1, 2019, and then decides to invest that $500,000 in gain in a Qualified Opportunity Zone investment on or before November 1, 2019. The tax on that gain is deferred until December 31, 2026 or until the investment is sold, whichever first occurs. If the investment is held at least five years, as of November 1, 2024, the basis in the investment will be increased by 10%, meaning $50,000 of the originally invested $500,000 gain is excluded from taxation. If the investment is held at least another two years (for a total of seven years), as of November 1, 2026 the basis in the investment will be increased by another 5%, meaning an additional $25,000 of the originally invested $500,000 is excluded from taxation. As of December 31, 2026, the remaining deferred gain of $425,000 ($500,000 minus $50,000 (the 5-year exclusion) and minus $25,000 (the 7-year exclusion) will be realized, with the result that taxes shall be due on $425,000 of the originally deferred gain as of the investor’s tax filing date in 2027.
Suppose also that in the
ten or more years following the initial investment of gain on October 1, 2019
the Qualified Opportunity Zone property in which the investment was made
appreciated substantially, with the result that the post-investment gain
attributable to the initial $500,000 investment (i.e. the gain after October 1,
2019) is $2,000,000. Under IRC
§1400Z-2(C), at the election of the taxpayer to step-up the basis of the
property to fair market value, the $2,000,000 post-investment gain is excluded
from taxation.
OPPORTUNITY ZONES AS SOCIAL-IMPACT LEGISLATION
The
challenge for Opportunity Zone investing is that it is not enough to simply
“invest” and hold in an Opportunity Zone. Instead, either (i) the original use
of qualified opportunity zone business property must commence with the
investment of qualified opportunity funds, or (ii) if the property is already
in use, it must be substantially improved within thirty (30) months. Generally speaking, “substantial improvement” means improving the property by an amount
equal to the cost basis of the property upon acquisition by purchase after
December 31, 2017, less any amounts reasonably allocated to land. See: IRC
§1400Z-2(d)(2)(D).
Opportunity
Zones were designed to inspire social-impact projects. Investment projects in
Opportunity Zones are supposed to make a positive difference for the low-income
community in which it is situated. The investor seeking the tax advantages of
investing in a Qualified Opportunity Zone must put its funds to work to create
economic opportunity in the community. Merely investing in an existing property
or business is not enough.
SECTION 1031 TAX BENEFIT vs. OPPORTUNITY ZONE TAX BENEFIT
A question I am often asked is whether an Opportunity Zone Investment is better than a tax-deferred exchange pursuant to IRC Section 1031? The short answer is that one is not inherently better than the other, they are just different. It’s like asking whether penicillin is better than a sandwich. Clearly, if you are merely starving a sandwich is better. If you have a bacterial infection, you might be better off using penicillin. The tax benefits of investing in a Qualified Opportunity Zone are different from the tax benefits offered by a tax deferred exchange of like-kind property pursuant to IRC Section 1031, and the circumstances under which each may be beneficial are different. Each has its place. I will be posting an updated article on IRC Section 1031 tax-deferred exchanges shortly.
OPPORTUNITY ZONES AS ECONOMIC DEVELOPMENT INCENTIVE
Qualified Opportunity Zone investments in real property require significant capital improvements and the acceptance of a substantial degree of investment risk. The investment risk is that the property must yield acceptable investor returns to sustain the project over a holding period of at least 5 years, but ideally 10 years, and that during the 10-year holding period the property will substantially appreciate in value, making the promised exclusion of gain taxation meaningful. Because of the substantial investment required to substantially improve property (i.e. double the basis of the existing improvements) and the uncertainty that the primary tax benefit to be derived from appreciation in value over 10 or more years will be achieved, today’s value of property is not automatically enhanced merely because it is located within an Opportunity Zone as some existing owners seem to believe. The project itself must make substantial economic sense on its own – just as if it were not in an Opportunity Zone. The tax benefits available through a Qualified Opportunity Zone investment will not make a poor investment or a marginal investment good. They will only make a good investment better.
What makes a Qualified Opportunity Zone investment similar to a IRC Section 1031 Exchange is that they both provide for tax deferral. Tax deferral for a Section 1031 investment is potentially without end. Tax deferral for a Qualified Opportunity Zone investment is temporary, but carries with it the additional benefit of potential exclusion of gain from taxation. Section 1031 exchanges have been part of the Internal Revenue Code for nearly 100 years and are well understood as a tax deferral tool. Qualified Opportunity Zone investments are a brand-new tax mitigation tool authorized in December 2017, with the rules for their use still being written.
The potentially powerful tax incentives offered by Qualified Opportunity Zone investment, coupled with their focus on revitalizing economically distressed communities, is what has made investing in Opportunity Zones one of the hottest topics in real estate.
END*
*NOTE:
The foregoing article is for educational purposes and is not intended as tax
advice. Taxation of Opportunity Zone investments is highly technical and fact
sensitive. Consult with your own tax advisor when applying the subject matter
of this article to any specific tax scenario.
