The Opportunity Zone Program is new federal income tax incentive program designed to encourage private capital investment in Opportunity Zones (O-Zones), which are certain designated areas throughout the United States.
Opportunity Funds (O-Funds) act as intermediaries between O-Fund investors and the actual investments in the O-Zone. O-Funds are required to hold 90 percent of their assets in O-Zone Property.
Opportunity Zone Businesses
An O-Fund can satisfy the 90-percent requirement by making a direct cash equity investment after December 31, 2017, in a domestic corporation, partnership or limited liability company that constitutes an O-Zone Business at the time of investment, and for “substantially all” of the O-Fund’s holding period.
In order to qualify as an O-Zone Business, a number of requirements and restrictions similar to those applicable under the New Markets Tax Credit (NMTC) Program need to be satisfied, including, but not limited to, a prohibition on certain “sin” businesses. Additionally, substantially all the tangible property owned or leased by the business is required to be O-Zone Business Property, at least 50 percent of the gross income of the business is required to be derived from the active conduct of a trade or business, a substantial portion of the intangible property of the business is required to be used in the active conduct of such business, and no more than 5 percent of the average of the aggregate unadjusted tax bases of the property of the business can be comprised of what is called “nonqualified financial property.” Upcoming guidance should provide some clarity with respect to many of these rules. It is hoped this guidance will follow the rules applicable to the NMTC program – which is a mature industry with a fair amount of developed law.
Opportunity Zone Business Property
An O-Fund can satisfy the 90-percent requirement by directly acquiring O-Zone Business Property. Also, as noted above, “substantially all” of the tangible property of an O-Zone Business is required to be O-Zone Business Property.
O-Zone Business Property is tangible property used in a trade or business that was acquired by purchase from an unrelated person after December 31, 2017. Relatedness is based upon a “more than” 20 percent test. Also, to be considered as O-Zone Business Property, either the original use of such tangible property in the O-Zone must commence with the O-Fund or the O-Zone Business, or the O-Fund or the O-Zone Business must substantially improve the tangible property.
The substantial improvement requirement will likely be necessary for projects involving real estate, and requires that improvements are made to the tangible property during any 30-month period commencing after the acquisition date and the cost of the improvements must exceed the tax basis of the property at the beginning of the 30-month period (which would likely be the acquisition price of the property).
Tax Benefits to Investors
The Opportunity Zone Program provides three primary tax incentives to O-Fund investors.
First, an investor may defer any gain by investing all or a portion of such gain recognized from the sale or exchange of an asset with an unrelated person in an O-Fund within 180 days of the recognition event. The amount of gain to be deferred by the investor (Deferred Gain) is equal to the amount that the investor contributes to the O-Fund. The Deferred Gain is required to be included in income upon either the date the investor sells or exchanges his or her interest in the O-Fund or December 31, 2026, whichever is earlier. Second, to the extent that the taxpayer has held the interest in the O-Fund for five and seven years prior to December 31, 2026, the amount of the Deferred Gain to be included in income on December 31, 2026, may be reduced by up to 15 percent of the Deferred Gain.k
The third major benefit of the program occurs when the investor holds an interest in the O-Fund for at least 10 years. In such a case, investors may make an election to increase the tax basis of their investment in the O-Fund to the investment’s fair market value on the date of a disposition of such an interest, thereby eliminating any taxable gain. This is where much of the excitement in the program has been generated because it allows investors to obtain tax-free appreciation on their O-Fund investment. Still, O-Funds and investors need to be cognizant that the Deferred Gain will be taxable on December 31, 2026 — which is prior to the 10-year holding benefit.
The Opportunity Zone Program is an exciting new tax incentive program that offers substantial opportunities for its participants. We need guidance from Treasury to answer many of the deployment questions. Once this guidance is issued, the Opportunity Zone industry will move quickly, and it is important not to be left behind.
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: Taking Advantage of a New and Significant Capital Source (June 2018)
Part 2: Deployment of Capital: parameters and tax benefits (July 2018)
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