Buried in the recently enacted Tax Cuts and Jobs Act was the creation of the Opportunity Zone Program. This new federal income tax incentive program is designed to encourage private capital investment in Opportunity Zones — designated distressed communities throughout the United States (including possessions of the United States). Specifically, the Opportunity Zone Program seeks to attract private capital for investment in projects and businesses located in economically distressed areas by providing significant tax incentives to investors in the form of the long-term deferral of taxable gain, a partial reduction in the amount of such long-term deferred taxable gain, and the exclusion of gain resulting from appreciation in the investor’s capital investment. This last tax benefit is generating a tremendous amount of excitement.
The Opportunity Zone program was first introduced in 2016 and later re-introduced in early 2017 with bipartisan support as the Investment in Opportunity Act. Conceptually, it is similar to the highly successful New Markets Tax Credit Program and adopts many of the same rules. However, unlike the NMTC Program, the Opportunity Zone Program does not require an overall cap in the amount of its subsidy, and as a result the potential investor base is unprecedented, with an estimated $6 trillion in investment potential. Essentially, anyone who recognizes a gain is a potential investor in this program.
In order to understand how to benefit from the Opportunity Zone Program, one needs to understand the following critical components:
- Where are the Opportunity Zones (O-Zones) located?
- How do you form an Opportunity Fund (O-Fund)?
- What are the parameters surrounding the deployment of capital by an O-Fund?
- What are the tax benefits available to O-Fund investors?
- This article will address the first two of the above; next month’s article will address the second two.
The United States is divided into approximately 74,000 population census tracts. Each of the 50 states, the District of Columbia and all U.S. possessions have population census tracts that are considered distressed (Distressed Census Tracts) based upon certain economic data, which comprises about 37 percent of all of the census tracts in the United States. Interestingly, the criteria for a census tract to be considered distressed is identical to what is used in the NMTC Program.
Twenty-five percent of the Distressed Census Tracts in each state and possession were eligible for nomination for certification by the Treasury Department as O-Zones. As an aside, 5 percent of the nominated census tracts could be tracts that do not qualify as being Distressed Census Tracts but are contiguous to nominated Distressed Census Tracts. Approximately 8,000 census tracts (or 11 percent of all of the existing population census tracts) were nominated and certified by the Treasury Department with the O-Zone designation. The list of designated Qualified Opportunity Zones is available on the Treasury Department’s Opportunity Zone resource page.
In order to participate as an investor and obtain the tax benefits described herein, a taxpayer recognizing a gain from the sale or exchange of an asset is required to invest all or a portion of the gain in an O-Fund within 180 days of the date of the sale or exchange. An O-fund serves as an intermediary between the investor and the investment in the O-Zone.
An O-Fund is an investment vehicle that is organized as either a corporation or a partnership for federal income tax purposes, is certified by the Treasury Department, and holds at least 90 percent of its assets, on average, in Opportunity Zone Property. Compliance with the 90-percent requirement is tested twice per year, with a monthly penalty for failure to comply. The certification process with the Treasury Department involves self-certification. Treasury has not yet issued any guidance as to what exactly needs to be certified.
Deployment of Capital By the O-Fund: Opportunity Zone Property
Opportunity Zone Property (O-Zone Property) may consist of certain stock and partnership interests called “Opportunity Zone Businesses” and certain business property called “Opportunity Zone Business Property.” Effectively, the O-Fund can make an equity investment directly in an O-Zone Business or can acquire O-Zone Property where the O-Fund is the direct owner of such property. The O-Fund cannot make a loan to satisfy the 90-percent O-Zone Property test, but preferred equity should be fine as long as it is considered equity for federal income tax purposes.
Finally, because nonprofit corporations do not have stockholders, it is not possible for an O-Fund to invest directly in a nonprofit corporation. That said, it may be possible for an O-Fund to acquire O-Zone Property and lease such property to a nonprofit corporation or for an O-Fund to enter into a joint venture (such as a limited liability company) with a nonprofit corporation.
Marc Schultz is a partner in Snell & Wilmer’s Phoenix office whose practice is concentrated in federal, local and state taxation matters, including complex transactions involving corporate, limited liability companies, limited partnerships, tax exempt entities and real property. Schultz currently chairs Snell & Wilmer’s Tax Credit Finance, Renewable Energy, and Opportunity Zones and Opportunity Funds groups, and is a frequent speaker and panelist on the New Markets Tax Credit program as well as the emerging impact of Opportunity Zones and Opportunity Funds. He is a graduate of Chicago-Kent College of Law (J.D.) and New York University School of Law (LL.M. Taxation) and formerly served on the board of directors for the Arizona Housing Finance Authority as an appointment by Arizona Governor Doug Ducey.
The Opportunity Zone Program: A Two-Part Series
Part 1: The Opportunity Zone Program: Taking advantage of a new and significant capital source (June 2018)
To reference published segments, please access the archived “Legal” articles on the In Business Magazine website, www.inbusinessPHX.com.