The 2017 Tax Cuts and Jobs Act that went into effect this past February contains a new program called “opportunity zones,” which incentivizes investments and job creation in economically distressed communities. In October of 2018, the U.S. Treasury Department unveiled a number of new rules and regulations designed to provide clarity and answer lingering questions about the tax implications of investing in these newly-designated areas, of which there are 879 in California alone. We turned to Allen Matkins partners and opportunity zone experts Matt Ertman and Mike Pruter to help explain this investment opportunity and how potential investors can capitalize on it.
What is an opportunity zone?
An opportunity zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. The Tax Cuts and Jobs Act, signed into law in December, 2017, created a new tax incentive program that encourages investors to make long-term financial investments in Qualified Opportunity Zones (QOZs). In exchange, the investor receives a number benefits related to the deferral of capital gains taxes.
How does one reap the tax benefits of investing in an opportunity zone?
In order to qualify for favorable tax treatment, a taxpayer must, within 180 days of a sale or exchange resulting in capital gains, invest the gain into a Qualified Opportunity Fund. This short timeline may prove challenging for investors, who will have to figure out the best way to acquire or repurpose their properties and assets within this short window.
What is a Qualified Opportunity Fund?
All investments in QOZs must first be invested in a Qualified Opportunity Fund. The Fund is an investment vehicle that is organized as a corporation or a partnership that utilizes the gains from a prior investment to capitalize the Fund. In order to be eligible for the benefits afforded by the Opportunity Zone program, the investor must invest the gain into a Fund within 180 days from the date of the sale or exchange that resulted in such gain.
The Fund must hold 90 percent of its assets in QOZ property, or a penalty is paid for failing to meet this requirement. An exception to this rule can be made if it is shown that failure to maintain the 90 percent requirement is due to reasonable cause.
What are the potential benefits of investments in Qualified Opportunity Funds?
The three main incentives for taxpayers to invest their gains in QOZs are to defer recognition of capital gains, to eliminate recognition of up to 15 percent of these capital gains, and to potentially eliminate recognition of all capital gains upon the sale or exchange of a Fund investment.
These Qualified Opportunity Funds are very different than traditional funds, and investors will have to be creative to structure them correctly to comply with the codes in place.
What qualifies as QOZ Property?
There are three different types of QOZ Property:
- Qualified Opportunity Zone Stock is stock in a U.S. corporation that is a QOZ business
- Qualified Opportunity Zone Partnership Interest is any capital or profits interest in a U.S. partnership that is a QOZ business
- Qualified Opportunity Zone Business Property is tangible property used in a trade or business of a Qualified Opportunity Fund.
All three types must be acquired solely for cash, must have been a QOZ Business when acquired and must qualify as a QOZ business during substantially all of the Fund’s holding period.
How is a QOZ Business defined?
A QOZ Business is any trade or business that meets all of the following requirements:
- At least 70 percent of the tangible property it owns or leases was purchased after December 31, 2017
- It is the first to use the property in the QOZ, or it must substantially improve the property
- The property must be used in the QOZ during substantially all of the QOZ business’s holding period
- At least 50 percent of the total gross income of the QOZ Business is derived from the active conduct of business in the QOZ
- A substantial portion of the QOZ business’s intangible property is used in the active conduct of business in the QOZ
- Less than 5 percent of the QOZ business’s property is attributable to nonqualified financial property, which includes debt instruments, stock, partnership interests, annuities, and derivative financial instruments
- The QOZ business cannot be a country club, massage parlor, hot tub facility, racetrack, health club, or store whose principal business is the sale of alcoholic beverages for consumption off premises.
How does one find a qualified Opportunity Zone in which to invest?
If you’re looking to participate in this program, you must first identify an investment within a QOZ. QOZs are economically distressed communities which have been nominated as a QOZ by a state and certified as such by the U.S. Treasury.
California Governor Jerry Brown nominated certain areas as QOZs earlier in the year, and the U.S. Treasury completed the process by designating almost 900 of these areas in California as QOZs, expiring at the end of 2028. Potential investors can use a mapping tool made publicly available through the U.S. Treasury to determine if a piece of property is designated as a QOZ: https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml
What are some of the remaining issues requiring regulatory clarification?
On October 19, 2018, the U.S. Treasury Department and the Internal Revenue Service issued proposed regulations that address some of the significant questions arising under the new legislation, but a number of significant issues remain unclear. A second set of regulations are expected to be issued before year-end. Among some of the remaining issues are (1) whether and the extent of any grace period that will be provided for a Fund to reinvest investor capital in QOZ Property; (2) whether debt financed returns of capital to investors will be considered sales or exchanges for purposes of the end of the tax deferral period; and (3) the treatment of interim gains on sales or exchanges of QOZ Property of the Fund and the reinvestment of such gains by the Fund during the Fund term.
About Allen Matkins’s Opportunity Zones Fund Team
Led by Partners Matt Ertman and Mike Pruter, the Allen Matkins Opportunity Zones Fund Team is at the forefront of the evolving Opportunity Zone investment strategy since this legislation passed, working hand-in-hand with advisors involved with the US Treasury Department in promulgating regulations and end user clients in the formation of and investment in Opportunity Zone Funds.
The Opportunity Zones Fund Team counsels clients on all aspects of Opportunity Zone investments— ensuring they are compliant with evolving federal regulations for this program and guiding them through the unique logistical and legal issues related to this new investment structure. The team works with fund managers and investment and real estate professionals in forming Quality Opportunity Funds, and can also assist with tax structuring, business investments, asset purchases and sales, and any other facet of this developing field. For more information contact Matt Ertman at: mertman /at/ allenmatkins.com.