The 2017 Tax Act introduced a new program to incentivize investment in low-income communities that have been designated Opportunity Zones by encouraging taxpayers to capture capital gains in current investments and reinvest those gains in the Opportunity Zones to obtain significant tax benefits. The economic and tax incentive benefits underlying Opportunity Zone Funds are attractive to both project sponsors and investors. However, the speed with which Section 1400Z-2 was drafted has resulted in numerous open questions and unknowns that make application of the new law an inherently risky venture. Potential sponsors and investors need to be fully aware of such risks and their implications, at least until sufficient guidance is issued.
The below is a summary of certain aspects of the new law, and although not comprehensive, is intended to touch on some of the specific issues raised by application of the new law. The first batch of regulations are expected imminently. Part II of this Client Alert will address those regulations and how they impact the current uncertainty with Opportunity Zone Funds.
Section 1400Z-2(a)(1) provides that, at the election of a taxpayer, gross income for the taxable year will not include that portion of gain arising from the sale or exchange with an unrelated person of any property that is invested in a qualifying Fund during the 180-day period beginning on the date the property is sold or exchanged. The gain deferred under Section 1400Z-2 is required to be included in the taxpayer’s income in the earlier of (i) the year in which the taxpayer sells the Fund investment, or (ii) December 31, 2026 (collectively, the “Trigger Year”). Section 1400Z-2(b)(2)(B) provides special rules for calculating the taxpayer’s basis in the qualifying Fund investment, which in turn determines the benefit, if any, associated with timely rolling over the deferred gain into a qualifying Fund (aside from the time value of money benefit associated with tax deferral):
- First, the taxpayer’s initial basis in a Fund investment is deemed to be zero (with respect to the gain rolled-in to the Fund);
- Next, the taxpayer’s basis in a Fund investment is increased for the amount of gain previously recognized on the sale or exchange of the original investment, if any;
- Next, if the taxpayer holds the Fund investment for at least five years, the basis of the Fund investment is increased by an amount equal to 10 percent of the previously excluded (deferred) gain;
- Next, if the taxpayer holds the Fund investment for at least seven years, the basis of the Fund investment is increased by an additional 5 percent of the previously excluded (deferred) gain (resulting in a cumulative basis increase of 15 percent); and
- Finally, if (i) the taxpayer holds the Fund investment for at least 10 years, and (ii) the taxpayer makes an additional special election, the basis of the Fund investment is increased so that it equals the fair market value of the Fund investment on the date that investment is sold or exchanged (note that the basis would have also previously been increased by the mandatory tax event in the Triggering Year pursuant to taxation of 85% of the initially deferred gain).
A qualifying Fund is generally an investment vehicle that is organized as a corporation or a partnership for the purpose of investing in Zone Property and holds at least 90 percent of its assets in Zone Property. In most cases, particularly in the real estate development context, Funds will be single-project LLC structures investing directly in a project or indirectly in a project through a single-member LLC. Currently, the IRS neither pre-approves nor certifies Funds. Instead, eligible taxpayers self-certify as a Fund by attaching yet to be released form to their timely filed federal income tax return for the tax year. There is concern that the qualification process for a Fund may be expanded by regulation, and it is yet to be seen how future regulations would be applied to transactions that occur prior to the issuance of such regulations.
Zone Property means tangible property used in a trade or business of the Fund if:
- Such property was acquired by the Fund by purchase after December 31, 2017;
- The original use of such property in the Opportunity Zone commences with the Fund or the Fund substantially improves the property; and
- During substantially all of the Fund’s holding period for such property, substantially all of the use of such property was in a qualified zone.
Whether property meets the substantial improvement requirement depends on whether, during any 30-month period beginning after the date the property is acquired, additions to the property’s basis by the Fund exceed an amount equal to the adjusted basis of the property in the hands of the Fund at the start of the 30-month period.
The 90% Zone Property requirement is determined by the average of the percentage of qualified opportunity zone property held in the fund as measured on the last day of the first six month period in a tax year and on the last day of the tax year of the Fund. If the 90% threshold is not met, the Fund would be subject to a penalty for each month it fails to meet the requirement. The penalty equals the amount of fund assets that would need to be reallocated to investments in qualified opportunity zone property in order to satisfy the 90% investment standard, multiplied by the Section 6621(a)(2) underpayment rate for the month. There is much confusion as to how the 90% threshold applies in year one or two of a large real estate projects where it may take two or three years to expend the full cash investment and loan proceeds. Many, however, believe that a grace period for expending such amount will be part of future regulations, but that is not a guarantee. Further, no guidance has been issued on calculating the 90%, including whether it is done at a fair market value basis.
Many questions remain with respect to Opportunity Zone Funds, for example, how do you apply the 90% requirement? What steps will Funds have to take for qualification after future guidance is provided? Practitioners are hopeful that these and many other issues are resolved by the imminent guidance providing the much needed clarity and assurance for sponsors and investors contemplating such transactions.
This Client Alert is not intended to cover all aspects of Section 1400Z-2, but instead highlights some of the more important aspects and issues with the new tax investment strategy. This Client Alert is also intended to be general in nature and is not intended to provide advice or guidance with respect to your specific situation. Look forward to Part II of this Client Alert addressing the imminent guidance expected by Treasury Department. Meanwhile, if you have any questions, please contact Bradley Wooldridge at 919-510-9253 or your Manning Fulton relationship attorney.