By Thomas B. Eriksen, AttorneyThis article originally appeared in the December 2018 issue of the Oregon State Bar Business Section Newsletter.
The 2017 Tax Cuts and Jobs Act (“2017 Tax Reform”) includes new tax incentives designed to spur economic development in areas of the country determined to be disadvantaged. New Internal Revenue Code (“IRC”) Subchapter Z – Opportunity Funds provides three distinct tax incentives intended to encourage investors to invest capital into low-income areas of each state. All 50 governors had until March 21, 2018 to designate certain disadvantaged geographic areas within their state as “Opportunity Zones.” Interactive maps of Oregon[i] and national[ii] Opportunity Zones are available. Once the Opportunity Zones were designated, they may not be modified during the 10-year run of the Opportunity Fund tax provisions. It is interesting to note that some states relied on old (up to 10 years old) data to determine the location of their Opportunity Zones, raising some question as to the validity of some designations of disadvantaged areas. For example, the recently revived Vancouver, Washington waterfront is located in an Opportunity Zone; however, tens of millions of investment capital were already flowing into this area before the new tax incentives.
Deferral of Capital Gains. The first tax benefit is the deferral of capital gains upon the sale or exchange of a capital asset on or after January 1, 2018. The sale of any capital asset qualifies as long as it is sold to an unrelated party and the gains are reinvested in a Qualified Opportunity Fund within 180 days of the sale of the capital asset. Subject to the possibility of a step-up in basis discussed below, recognition of the capital gains may be deferred until December 31, 2026. Under the recently released proposed regulations implementing IRC Section 1400Z-2, the IRS clarified that taxpayers eligible to take advantage of the deferral include individual taxpayers, corporations (including REITs and RICs), partnerships, and certain trusts. A partnership may elect to defer part or all of the gain at the partnership level. If the partnership does not elect to defer the gain, a partner may elect to defer part or all of the partner’s distributive share of the gain. Under the sunset provisions of the new tax law, the deferral election applies to capital gains recognized prior to December 31, 2026.
Step-up in Basis. The second tax benefit is the possible step-up in basis on the deferred gain. If the investor holds the Qualified Opportunity Fund investment for five years, the investor receives a 10% step-up in basis on the deferred capital gains. If the investor holds the Qualified Opportunity Fund investment two additional years, for a total of seven years, the investor receives an additional 5% step-up in basis, for a total of a 15% step-up in basis. Accordingly, for each $100 of deferred gain held in a Qualified Opportunity Fund investment for seven years or more, only $85 of that gain will ultimately be subject to capital gains taxation. The proposed regulations allow taxpayers to make the step-up in basis election until December 31, 2047, thus allowing the step-up in basis after the initial designation expires on December 31, 2028. This provides the investor the opportunity to hold the Qualified Opportunity Fund investment for the entire required 10-year holding period, plus an additional 10 years, and allows investors to acquire Qualified Opportunity Fund investments at any time prior to the December 31, 2028 expiration and still take advantage of the step-up in basis opportunity.
Exclusion of Gain. The third tax benefit of the new Opportunity Fund tax provisions is the possible permanent exclusion of all of the gain on the appreciation in value of the Opportunity Fund investment. If the Opportunity Fund investment is held for 10 years or more, all of the increase in value of the Opportunity Fund investment is excluded from capital gains taxation. In this scenario, the investor will pay capital gains tax on 85% of the capital gains deferred on the initial sale of the capital asset; however, any gains on the funds reinvested in the Opportunity Fund permanently avoid taxation.
Qualified Opportunity Fund. As noted above, an investor has 180 days from the sale or exchange of a capital asset to invest the gains in a Qualified Opportunity Fund. The Qualified Opportunity Fund must in turn hold at least 90% of its assets in Qualified Opportunity Zone Property. The 90% standard is measured on the last day of the first 6-month period of the taxable year of the Fund and on the last day of the taxable year of the Fund (more on Qualified Opportunity Zone Property below). A Qualified Opportunity Fund is defined in the IRC as “any investment vehicle which is organized as a corporation or partnership” for the purpose of investing in Qualified Opportunity Zone Property. By using the term “organized” as a corporation or partnership, rather than “taxed” as a corporation or partnership, there was initially some question and concern whether a limited liability company satisfied the definition of a Qualified Opportunity Fund. Fortunately, the proposed regulations issued October 19, 2018 answered this question in the affirmative, clarifying that a Qualified Opportunity Fund includes entities treated for federal income tax purposes as a corporation or partnership (thus including limited liability companies taxed as either).
Qualified Opportunity Zone Property. The gains invested in the Qualified Opportunity Fund must be used to purchase Qualified Opportunity Zone Property. Qualified Opportunity Zone Property comes in three flavors. The first is a capital or profits interest in a domestic partnership (or LLC) that qualifies as a Qualified Opportunity Zone Business acquired after December 31, 2017. The second is stock of a domestic corporation that qualifies as a Qualified Opportunity Zone Business acquired after December 31, 2017, either directly from the corporation or through an underwriter solely in exchange for cash. Finally, Qualified Opportunity Zone Property is defined as Qualified Opportunity Zone Business Property (addressed in detail below).
Qualified Opportunity Fund Business Property. While a Qualified Opportunity Fund may be a corporation, partnership, or limited liability company, ultimately, the Fund must own Qualified Opportunity Zone Business Property, which is defined as tangible property used in a trade or business, acquired by purchase from an unrelated party after December 31, 2017. The original use of the property must commence with the Qualified Opportunity Fund or the Fund must substantially improve the property, and during the holding period by the Fund, substantially all of the use of the property must be in a Qualified Opportunity Zone. Revenue Ruling 2018-29 explores in detail the “original use” and “substantial improvement” requirements for Qualified Opportunity Zone Business Property.
In order for a partnership (LLC) or corporation to be a Qualified Opportunity Zone Business, it must conduct a trade or business in which substantially all of the tangible property used by the business is Qualified Opportunity Zone Business Property, at least 50% of the gross income of the business is derived from the active conduct of the business, a substantial portion of any intangible property is used in the active conduct of the business, and less than 50% of the average aggregate unadjusted basis of the property is attributable to nonqualified financial property. Last, but certainly not least, the property may not be a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, a facility used for gambling or any store, the principal business of which is selling alcohol for off-premises consumption.
Notwithstanding the very technical and involved IRC definitions for a Qualified Opportunity Fund Business Property, the IRS allows the Fund to self-certify that it is a Qualified Opportunity Fund.
Conclusion. As with any tax incentives in the IRC, there are numerous qualifications, definitions, and limitations applicable to the new Opportunity Fund incentives. A deep dive into IRC Subchapter Z, the proposed Treasury regulations, and Revenue Ruling 2018-29 is necessary to confirm eligibility for any of the three possible tax benefits. It is also important to remember that while a Qualified Opportunity Fund may be established at any time, the initial deferral of gain and the opportunity to take advantage of the step-up in basis and the exclusion of gain is limited by the December 31, 2026 sunsetting of that provision of the 2017 Tax Reform.