Capital gains tax has been generating a lot of buzz recently, and not only because the current administration has asked the Treasury Department to look into new ways to reduce it. One of the hidden gems of the recent tax-reform legislation is opportunity zones (generally referred to as o-zones) and the ability to defer, reduce and eliminate realized and future capital gain taxes as a result of certain investments.

The Tax Cuts and Jobs Act of 2017 established the federal opportunity zones program, a new community reinvestment tool designed to use tax incentives to drive long-term investments to rural and low-income urban communities throughout the nation. The o-zone program is the first new national community investment program in more than 15 years and has the potential to be the largest economic development program in the United States. The purpose of the legislation is to spur private investment in low-income census tracts by providing for a temporary deferral of tax on capital gains, a reduction in the amount of capital gains tax that must ultimately be paid, and tax-free appreciation — subject to certain conditions — in special investment vehicles known as “qualified opportunity zone” funds, or opportunity funds (sometimes referred to as o-funds).

This broad legislation will benefit not only such communities, but also many stakeholders, including:

• Real estate developers seeking equity investments for their developments in o-zones
• Sponsors, syndicators and private equity funds looking to create o-funds that will then invest in projects located in o-zones
• Individual taxpayers with gain, or the ability to create gain, looking to defer and reduce the tax paid on such gain
• Businesses formed after Dec. 31, 2017, located in an o-zone and that satisfy the requirements of being a qualified opportunity-zone business

THE BENEFITS OF O-ZONE INVESTMENT

Taxpayers who invest gains in an o-fund enjoy deferred taxes, gain reduction and appreciation exclusion.

Tax on the gain invested in the o-fund is deferred until either the date a taxpayer sells its interest in the o-fund or Dec. 31, 2026, whichever comes first.

If a taxpayer holds its ownership interest in the o-fund for at least five years, then 10 percent of the gain invested is excluded from the tax owed upon the sale of the taxpayer’s interest in the o-fund (or 2026, whichever is earlier). If the ownership interest is held for at least seven years, an additional 5 percent (for a total of 15 percent) of the invested gain is excluded from the tax owed upon the sale of the interest in the o-fund (or 2026, whichever is earlier).

If a taxpayer holds its ownership interest in an o-fund for at least 10 years, then all appreciation in the investment will be tax-free when the taxpayer sells its interest.

To take full advantage of the statute’s current benefits (i.e., deferral of tax until 2026 and 15 percent reduction in taxable gain), investments must be made by the end of 2019. This does not mean taxpayers cannot make investments after 2019 to take advantage of the benefits, including the appreciation exclusion that many believe is the greatest benefit of the new law.

HOW O-ZONE LEGISLATION WORKS

The o-zone legislation is a creature of the tax code. As such, one must be mindful of the technical and sometimes contradictory and ambiguous definitions and terms set forth. The following terms establish the framework.

Opportunity zones are low-income census tracts, or census tracts contiguous with a low-income census tract, which were nominated by the chief executive of a state or territory (typically the governor of the state in which it is located) and have been certified by the Treasury Department. There are currently 8,760 certified opportunity zones nationwide, located in a mix of urban, suburban and rural geographies.

An opportunity fund is a corporation or partnership organized to invest in “qualified opportunity-zone property” or QOZP. Many believe an o-fund can also be a limited liability company. An o-fund must hold at least 90 percent of its assets in such QOZP, measured every six months of each calendar or fiscal year of the o-fund, and failure to maintain the 90 percent investment requirement results in a penalty. The penalty calculation, while difficult to calculate, is severe. An o-fund can include both capital gains and other funds, but only the capital gains are eligible for the o-zone tax benefits of deferral, reduction and exclusion.

The o-zone statute has created certain time pressures to drive investment. For a taxpayer to qualify for the benefits under the statute, for example, capital gains must be invested in an o-fund within 180 days from the date they are realized. Because of the 90 percent investment requirement, the o-fund must be cognizant to deploy its capital timely and otherwise invest such gains properly in a business located in an o-zone, or purchase QOZP. Thereafter, the opportunity fund must hold at least 90 percent of its assets in QOZP.

Given the statute is designed to spur investment activity in certain areas, it is anticipated many o-funds will invest in real property. Based on the legislation, QOZP can be real property used or located in an opportunity zone that was purchased after 2017 and (x) the original use of such property in such o-zone commences with the qualified o-zone business; or (y) such property is substantially improved following purchase by the o-fund. It is understood the “substantial improvement” test means an o-fund must increase the basis of the property by the amount of the original basis; said another way, if the o-fund buys the property for $1 million, then the costs of the improvements must be $1 million and $1. An o-fund has 30 months to complete such substantial improvements.

In addition, an o-fund may purchase a qualified opportunity-zone business, or stock or a partnership interest in such business, provided such stock or partnership interest was acquired by the o-fund after 2017 for cash. A qualified opportunity-zone business is any business in which substantially all of the tangible property owned or leased by the business was purchased after 2017, and substantially all of the use of that property is located in an o-zone. Also:

• At least 50 percent of the total gross income of the business must be derived from the active conduct of the business
• A substantial portion of the intangible property of the business must be used in the active conduct of the business
• Only a small portion of the business’s property can be financial instruments

Regardless of these factors, in no circumstances can a qualified opportunity-zone business operate certain designated types of business (e.g., gambling facilities, racetracks, liquor stores).

EXAMPLES OF OPPORTUNITY-ZONE INVESTMENTS

Assume a taxpayer has $100 in gain from the sale of stock June 1, 2018. The taxpayer invests the $100 gain in an o-fund that invests properly in an o-zone and QOZP.

First benefit: The $100 gain is not subject to tax in 2018 (the year of the sale of stock) and is deferred until the taxpayer’s investment in the o-fund is sold, or Dec. 31, 2026.

Second benefit: If the taxpayer’s investment in the o-fund is held for five years, then 90 percent is taxed in 2023; if the taxpayer’s investment in the o-fund is held for seven years, then only 85 percent of the $100 gain ($85) is taxed in 2025.

Third benefit: In addition, if the taxpayer sells his investment in the o-fund in 2029 or later (i.e., at least 10 years after the original investment in the o-fund) for $200, then no tax is paid on the $100 of appreciation of the investment.

Consequently, as a result of holding the $100 gain as an investment in an o-fund for 10 years, an investor would save $23.37 in tax and would get the benefit of the deferral of tax on the gain that is invested in the o-fund until 2026.

CONCLUSION

The opportunity-zone legislation is uncapped in its potential to trigger economic activity in, and for the benefit of, low-income communities. The options provided by the o-zone legislation will encourage many real estate and private equity participants to structure transactions that allow taxpayers to enjoy the many benefits of this new law. We expect increased awareness and use of o-funds as more guidance and understanding of the law unfolds.

John Balboni (jbalboni@sandw.com) is a partner in the real estate and corporate departments of Sullivan & Worcester LLP, and Michael Fenn (mfenn@sandw.com) is a counsel in the firm’s real estate group.