The recent tax act passed in December 2017, formerly known as the Tax Cut and Jobs Act (“2017 Act”), contains tax incentives designed to encourage new investment in low income communities within the United States. The 2017 Act establishes a procedure for the governor of each state to nominate special low income regions within the state called Qualified Opportunity Zones. The state governor’s nominations are then certified by the Internal Revenue Service (“IRS”) as “Designated Qualified Opportunity Zones.” As of the date of this article, California has completed the nomination process and has received a certification from the IRS establishing Designated Qualified Opportunity Zones to encourage new business and investment activity in low income regions. Many other states have also completed the certification process. To learn more about the regions designated in California, see http://dof.ca.gov/Forecasting/Demographics/opportunity_zones/.
An investor’s investment in an Opportunity Zone Fund (defined below) permits an investor to defer paying tax on capital gain realized by the investor in another taxable transaction. For example, if an investor sells real estate, stock or business assets in a taxable transaction, the investor can defer recognition of the gain and avoid paying federal income tax by reinvesting in a corporation, partnership, limited partnership, limited liability company or other business entity in which at least 90% of its assets are located in a Designated Qualified Opportunity Zone (“Opportunity Zone Fund”). To qualify for such deferral, the investor must reinvest the amount of gain for which deferral is sought in an Opportunity Zone Fund within 180 days from the date of the taxable sale or exchange.
Reinvestment in an Opportunity Zone Fund defers recognition of taxable gain from the date of the taxable sale until the earlier of: (i) the investor’s sale or liquidation of the investor’s interest in the Opportunity Zone Fund (“Opportunity Zone Investment”), or (ii) December 31, 2026. Additionally, through a basis adjustment, the deferred gain inherent in the Opportunity Zone Investment is reduced by 10% after the investment has been held for five years, and by an additional 5% after seven years. If the investor holds the Opportunity Zone Investment on December 31, 2026, then, regardless of whether he or she continues to hold the investment, the investor must recognize the deferred gain on that day, subject to any basis increases received for holding the property for five or seven years. If the investor holds the Opportunity Zone Investment after December 31, 2026, and for at least ten years, the investor receives a stepped-up basis in the Opportunity Zone Investment to fair market value and future appreciation is not subject to tax. Subject to the occurrence of the recognition event in December 2026, recognition of deferred gain can be substantially reduced.
To illustrate this concept, assume an investor sells stock or other investment assets which results in a realized gain of $10,000,000 (the proceeds received by the investor in the sale might have been much greater depending on the investor’s income tax basis in the asset when sold). If the investor then decides to reinvest $6,000,000 in an Opportunity Zone Fund within 180 days following the sale, the investor’s recognized gain from the earlier taxable transaction is reduced by the same amount and is deferred. At least initially, the deferred gain is transferred to the Opportunity Zone Investment. The $6,000,000 in deferred gain results a current federal tax savings of $1,200,000 where the deferred gain is computed at the federal long-term rate of 20%.
Continuing the above illustration, the investor would recognize the remaining $4,000,000 in taxable gain in the year of the sale. Had the investor reinvested the entire $10,000,000 of realized gain in an Opportunity Zone Fund, 100% of the gain realized on the investor’s earlier taxable sale would have been deferred. The investor’s deferred gain, now residing in the Opportunity Zone Investment, is reduced by 10% after the investment is held for at least five years, and by an additional 5% after the investment is held at least seven years. For this investor, the $6,000,000 deferred gain would be reduced by $900,000 after seven years. In other words, the $900,000 reduction in deferred gain is forever excluded from tax. As mentioned above, the investor would pay tax on any deferred gain deferred in the Opportunity Zone Investment on December 31, 2026. Thereafter, if the investment is continued three more years (for a total holding period of ten years), the investor’s basis in the Opportunity Zone Investment is stepped up to fair market value, including future appreciation.
There is no analogue for the deferral mechanism provided by the 2017 Act apart from the investor’s death! Unlike the requirements for “like-kind” exchanges under Internal Revenue Code Section 1031 (“1031 Exchange”), the investor may actually receive the proceeds of the taxable sale directly. Any taxable gain resulting from the sale can be deferred with a subsequent investment in an Opportunity Zone Fund, so long as the reinvestment occurs within 180 days of the taxable sale. Although a 1031 Exchange shares the same 180 day reinvestment requirement, all of the sale proceeds received by the investor must be assigned to a qualified intermediary before closing, and all such sale proceeds must be reinvested in like-kind replacement property. Any cash, received by the investor in the exchange transaction, including amounts representing the investor’s unreturned basis in the property sold, trigger recognition of gain. These new rules are much more generous.
The new law is silent as to whether the 3.8% Net Investment Income Tax (“NIIT”) is also deferred. Since the NIIT is calculated based on the gain taken into account in computing taxable income for the year, it would seem to be deferred to the same extent that it would be in a 1031 Exchange. There are many other significant open questions for which we expect guidance from the IRS in the future.
Given the new tax deferral opportunity, we expect syndications of Opportunity Zone Funds to significantly increase in the future. Due diligence is necessary to make sure that the benefit will be associated with reasonable investment risks. When considering ways to reduce your gain, keep in mind the economic choices that you are making when investing in Opportunity Zone Funds. We note that a 1031 Exchange out of an Opportunity Zone Investment will likely not be possible when the investment is liquidated. Our attorneys can work with you, your financial advisor and CPA to advise you in connection with the sale of your business or investment assets and can assist you with any decision to invest in an Opportunity Zone Fund.
Legal disclaimer: The information in this article (i) is provided for general informational purposes only, (ii) is not provided in the course of and does not create or constitute an attorney-client relationship, (iii) is not intended as a solicitation, (iv) is not intended to convey or constitute legal advice, and (v) is not a substitute for obtaining legal advice from a qualified attorney. You should not act upon any of the information in this article without first seeking qualified professional counsel on your specific matter.