The Tax Cut and Jobs Act, signed into law on December 22, 2017, created a new tax incentive program designed to attract both institutional and “impact investors” to make long-term investments in low-income communities. In exchange, investors are eligible to receive a number of benefits related to the deferral of capital gains taxes. The Treasury Department has estimated that these incentives will bring $100 billion of investment into these low-income communities.
The new tax law implements this program through two new provisions of the Internal Revenue Code, Sections 1400Z-1 and 1400Z-2. The Treasury Department recently released Proposed Regulations and other administrative guidance on these new provisions.
Code Section 1400Z-1 charged the Governor of each State with identifying low-income communities, based upon census tracts, to be “qualified opportunity zones” (“QOZ”). In California, there are 879 QOZs, which encompasses approximately three million Californians. The State of California, Department of Finance website page identifies these QOZs.
Code Section 1400Z-2 provides the requirements that investors must satisfy in order to be eligible to take advantage of the tax benefits. Ultimately, an investor is eligible to (1) defer tax on capital gains invested in a Qualified Opportunity Fund (“QOF”), and (2) if those capital gains are held in the QOF for at least 10 years, then the investor may elect to increase the basis of its investment in the QOF to fair market value when the investment is sold.
More specifically, the Code provides that the tax on the capital gains originally deferred when invested in the QOF is deferred until the earlier of (1) the date on which the investment in the QOF is sold, or (2) December 31, 2026. However, if the taxpayer holds its investment in the QOF for at least five years, then the taxpayer is eligible to receive a step-up in its basis in its investment in the QOF in an amount equal to 10 percent of the gain the taxpayer deferred when it invested in the QOF. And, if the taxpayer holds its investment for seven years, then the taxpayer is eligible to increase the basis of its investment an additional five percent. If the taxpayer holds its investment in the QOF for at least 10 years, then the taxpayer is eligible to increase the basis of its investment in the QOF to fair market value when the investment is sold.
The capital gains that are invested in a QOF are only eligible for this beneficial tax treatment if they are invested within 180 days of the transaction that generated the capital gains. In addition, the transaction must be with an unrelated person. The proposed regulations also clarify that an “eligible taxpayer” is any taxpayer that recognizes capital gains. Therefore, individuals, corporations, and partnerships are eligible to invest their capital gains in a QOF and receive the beneficial tax treatment.
A QOF is an investment vehicle that must be organized as a corporation or partnership for tax purposes (e.g., a Limited Partnership or a Limited Liability Company). The QOF must invest at least 90 percent of its assets in Qualified Opportunity Zone Property (“QOZP”) within 31 months of the commencement of the QOF. The Proposed Regulations provide further guidance on satisfying this 90-Percent Asset Test, including a safe-harbor for working capital (i.e., cash). The Proposed Regulations provide that a QOF “self-certifies” that it meets all of the requirements set forth in the Code. The IRS has proposed new Form 8996 on which the QOF will certify that it meets these requirements.
The Code provides for three types of QOZP: (1) Qualified Opportunity Zone Stock: new stock in a U.S. corporation organized as a Qualified Opportunity Zone Business (“QOZB”); (2) Qualified Opportunity Zone Partnership Interest: new capital or profits interest in a U.S. partnership organized as a QOZB; and (3) Qualified Opportunity Zone Business Property (“QOZBP”): property used in the trade or business of the QOF, provided that the property’s “original use” commences with the QOF, or the QOF “substantially improves” the property within 30 months of its acquisition by the QOF. A QOZB is a business that uses QOZBP in a trade or business within a QOZ. However, the Proposed Regulations exclude certain “sin” businesses, including golf courses, country clubs, massage parlors, hot tub and suntan facilities, gambling facilities, and liquor stores.
Eric Tetrault recently made a presentation on this topic at the South County Economic Development Council Opportunity Zone Forum in San Diego. To learn more about his practice, click here.