Tax Incentives for Investments in Opportunity Zone FundsPDF
As a part of the 2017 Tax Cuts and Jobs Act, the U.S. Congress enacted a potentially disruptive tax break that would allow for certain investments to both defer existing capital gains and permanently exclude new gains — the tax lawyer's version of a grand slam. However, certain limitations placed on this incentive may cause many real estate investors to stay on the sidelines.
The new law created tax incentives for certain investments in designated lower-income communities known as opportunity zones, which allow taxpayers with recently realized capital gains to invest the gains in opportunity zones.
Depending on the specific circumstances, investors with capital gains are sometimes able to delay including those gains until a later year through a variety of tax-planning mechanisms. A favorite is a Section 1031 "like-kind" exchange, where a taxpayer disposes of an asset and acquires a replacement, thereby shooing off the tax man, but only until that replacement property is sold. The appeal of opportunity zones is that, if structured correctly, the taxpayer will defer the recently realized capital gain and permanently exclude all subsequent appreciation in the new investment.
Specifically, the potential tax benefits to an investor in a qualified opportunity fund (QOF) are:
- Taxation of the capital gain is deferred until the earlier of the disposition of the QOF interest or the end of 2026.
- If the investor holds the QOF interest for at least five years, 10 percent of the gain is permanently excluded from taxation via a step-up in the tax basis of the QOF investment.
- If the investor holds the QOF interest for at least seven years, 15 percent of the deferred gain will be permanently excluded.
- If the QOF interest is held for at least 10 years, all of the appreciation after the initial investment in the QOF is permanently excluded.
In North Carolina, there are 252 qualified zones, which are designated by census tracts and easily available online. The Charlotte-area opportunity zones include tracts in Gaston County, near Central Avenue and Albemarle Road, and in large portions of north Charlotte between I-85 and I-277.
So, what's the catch?
In order to qualify, a taxpayer must acquire an equity interest in a QOF rather than a direct investment in property. A taxpayer must invest all or a portion of its gain in a QOF within 180 days of realizing the gain, which may not give investors enough time to fully vet their investments without prior planning. A taxpayer may invest more than the gain previously realized, but the tax benefits are available only to the extent of that gain.
Structurally, a QOF can be a corporation, partnership or a multimember LLC and is not required to have a specific number of investors. It is likely that many QOFs will involve a single property or project.
Ordinarily, a QOF holding a direct interest in opportunity zone property must have 90 percent or more of its assets invested in such property. However, most QOFs will probably hold an interest in a subsidiary business entity rather than holding property directly. If the QOF follows this strategy, only 70 percent of the subsidiary’s assets must be in qualified opportunity zone property. Thus, with proper planning, an investor could reap the benefits of deferral and/or exclusion with only 63 percent of the QOF property located in the opportunity zone.
So what is holding back a rush of investor cash into opportunity zones? Primarily regulatory uncertainty. Although the IRS provided guidance about opportunity zones in October, there is still a large amount of uncertainty about many technical issues. In particular, it is unclear how to coordinate special opportunity zone rules with normal partnership tax regulations that are crucial to getting the business deal right. Further, because North Carolina has not adopted the opportunity zone provisions, any gains shielded from federal tax will be recognized on a taxpayer's North Carolina state income tax return. Lastly, the structure of the opportunity zone regime demands a particular type of investor: one is who simultaneously patient (willing to wait several years to exit an investment) and agile (able to invest within 180 days after realizing a previous capital gain).