As part of the Tax Cuts and Jobs Act (Sections 1400Z-1 and 14-00Z2 of the Internal Revenue Code), new capital gains exemptions were created for taxpayers that make investments in approximately 8,700 “opportunity zones” throughout the United States. These opportunity zones, nominated by state and local governments, include low income and economically distressed areas and cover roughly 12 percent of the land area of the United States.
The purpose of the tax exemption is to encourage investment in low-income or economically distressed areas. The statutory requirements for capturing the tax benefit lend themselves to real property investment over other asset classes, therefore the principal focus of investment activity to date has taken place with respect to that asset class. As a result of these policy changes, we expect that capital will be re-allocated to some of these new opportunity zones and the new investment vehicles that have been created to provide taxpayers with the opportunity to benefit from these new exemptions will continue to increase in popularity. A number of opportunity zones have been established in areas that are not generally considered to be economically blighted, creating an additional arbitrage opportunity for developers and investors. For example, the area in which Amazon had planned to build their (now abandoned) campus in Long Island City, New York, is considered an opportunity zone.
What you need to know
To qualify for the new capital gains exemptions, a taxpayer is required to invest a gain (within 180 days of realization) from a recent sale or exchange of property into a Qualified Opportunity Fund (QOF). A QOF is a new form of investment vehicle that is required to hold at least ninety percent of its assets in “qualified opportunity zone property”. “Qualified opportunity zone property” includes equity interests or business property located within an “opportunity zone”. Because of the relative ease of classification of real property as “located within an opportunity zone” (as compared, for example, to equity interests in a going concern), we anticipate that real estate investment will continue to be a significant element of the investment mandate of many QOFs.
In return for investing a gain from a recent sale or exchange of property into a QOF, the taxpayer would receive an interest in the QOF. The taxpayer is subsequently able to receive three different U.S. federal income tax benefits on the “reinvested capital gain” and their interest in the QOF:
- An immediate deferral of the reinvested capital gain until 2026;
- Upon the fifth and seventh anniversaries of the investment, the elimination of a portion (ten percent and five percent, respectively) of the reinvested capital gain; and
- After the tenth anniversary of the investment and upon the sale of the interest in the QOF, the realization of no gain on any economic appreciation of the “reinvested capital gain” (regardless of how much the interest has increased in value).
We anticipate that many of our clients have been or will be solicited to invest in Qualified Opportunity Funds. Proper diligence must be done to ensure that the applicable QOF is complying with all relevant statutory requirements. There are a number of issues left unresolved in the statute regarding, among other things, appropriate capital structuring of a QOF (including whether the payment of “carried interest” to the sponsor of a QOF is permissible) and properly structuring the sale of QOF assets. The Treasury department is currently tasked with writing and enforcing the rules around this legislation, and as they work together with Congress to sharpen these issues into focus, we expect that the burgeoning interest in QOF investing, especially with respect to real property investment, will grow exponentially.
Example
In 2018, a taxpayer sells an asset for $2,000. The asset had a basis of $1,000 and a fair market value of $2,000. As such, the taxpayer realizes a gain of $1,000 upon the sale of said asset.
The taxpayer reinvests the $1,000 capital gain in a QOF. The consequences to the taxpayer would be as follows:
- The taxpayer would not recognize the $1,000 capital gain in 2018, as a result of Benefit (i);
- The taxpayer would take a $0 basis in its interest in the QOF;
- In 2023 (the fifth anniversary of the investment), the taxpayer’s basis in its QOF interest would increase to $100, as a result of Benefit (ii);
- In 2025 (the seventh anniversary of the investment), the taxpayer’s basis in its QOF interest would increase by $50 to $150, as a result of Benefit (ii);
- In 2026, the taxpayer would recognize a gain of $850 (the initially deferred $1,000 gain less the QOF interest’s basis step-up of $150); and
After 2028, the taxpayer would recognize (in the applicable tax period) $0 on the gain from the appreciation of the QOF interest between 2018 and the date of the sale of the QOF interest (regardless of how much the interest has increased in value), as a result of Benefit (iii).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
