The 2017 Tax Cuts and Jobs Act includes the Opportunity Zones program, which is intended as a tool for revitalizing distressed areas and communities by encouraging investment in those areas.
After a first round of proposed regulations in October 2018, the Treasury Department issued a second round of guidance on April 17, 2019, that provides additional clarity for investors, taxpayers and regulators.
How opportunity zones plan to encourage investment
Under the Opportunity Zones program, taxpayers who sell an appreciated asset of any kind can defer taxes until as late as December 31, 2026, by investing in a qualified opportunity fund (QOF). The longer they hold the investment in the QOF, the greater their benefit. After five years, 10 percent of the deferred gain is excluded from taxes. After a total of seven years, another 5 percent is excluded. While that total 15 percent is the maximum amount that can be excluded, if a taxpayer holds the investment for a total of ten years or more, none of the gains earned from the QOF will be taxed.
A number of QOFs have already emerged, and investors can create their own. Each QOF must invest at least 90 percent of assets in Opportunity Zones, although the law does not otherwise define a QOF’s investments (i.e., its risk-and-return profile). As with any new investment vehicle, there are a variety of structures, fees and rates. Because QOFs themselves have no track record, investors will need to examine the offering partnerships or corporations carefully.
The types of investment that qualify
Each state and territory was required to separately identify its qualifying Opportunity Zones by April 2018. Generally, the Opportunity Zone program uses low-income community census tracts as the basis for determining areas eligible for an Opportunity Zone designation. Qualifying areas have an individual poverty rate of at least 20 percent and a median family income of no greater than 80 percent of the area median. States could also identify a limited number of contiguous areas as qualified Opportunity Zones.
There are 8,761 tracts nationally, based on various criteria. The complete list and map of the selected tracts can be found at Opportunity Zones Resources.
At least 50 percent of the gross income of a business created with QOF funds must be derived from operations in a qualified Opportunity Zone. That requirement was meant to control abuses, but it also limited the types of possible business to exclusively local ones. Recent changes include three safe harbor provisions and other tests that a business can use to qualify, and allow for expanding opportunities for internet, export and service businesses.
Will the opportunity zones really provide the right incentives?
The Opportunity Zones program is the first new community tax incentive since the New Markets Tax Credit in 2000. It is based on equity investment, which is unusual in community incentives (which are typically debt-based).
In fact, the 2017 tax cut, by lowering corporate taxes, made tax-based incentives such as the Low-Income Housing Tax Credit (LIHTC) — a big driver of investment in disadvantaged communities — less of a benefit to investors. Opportunity Zones should help to offset the resulting shortfall.
Investments that qualify for tax breaks are intended to encourage job-creating businesses, with the exception of “sin”-oriented businesses such as casinos and liquor stores. Nonetheless, many observers worry that much of the money will end up flowing to real estate development instead.
Opportunity Zones were in the news recently when it was revealed that Amazon, in placing its HQ2 in Queens, could take advantage of the program. Amazon later said they would not take advantage of the tax breaks, and eventually pulled out of the New York City location altogether. The Opportunity Zone Amazon chose was relatively more prosperous than most targets of Opportunity Zone investments.
Non-U.S. investors can also qualify
Non-U.S. entities can also take advantage of the tax deferral provisions of the Opportunity Zones program. Non-U.S. entities can form their own QOFs if they are U.S. taxpayers.
Non-U.S. entities are generally not subject to capital gains on a sale of personal property because such capital gains are sourced based on residence, and their residence is outside the U.S. Nonetheless, in the case of a sale of real property, a non-U.S. entity must recognize ordinary income under the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA provisions treat gains on the sales of real property as ordinary income, which is sourced in the U.S. and taxable for a non-U.S. entity.
While more guidance is needed from the IRS, there may be an opportunity for a non-U.S. entity to defer income when real property is sold and reinvested in a QOF. For example, a U.K. entity with an investment in real property in the U.S. may be able to sell the property at a gain and reinvest the proceeds in an investment in a QOF, thereby deferring FIRPTA gains under the Opportunity Zone provisions.
An experiment to watch
There is political pressure to more rigorously measure the results of initiatives such as the Opportunity Zones program, and it is true that social programs are often short on intensive data collection. Still, a capital-based investment in disadvantaged areas, and one that keeps the capital working for at least a decade, has a good chance of showing positive results for both investors and the affected communities.
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