The Opportunity Zones incentive is an investment tool established by Congress in the Tax Cuts and Jobs Act of 2017 to encourage nationwide long-term investments in low-income urban and rural communities. Opportunity Zones provide a tax incentive for investors to re-invest their unrealized capital gains into dedicated Opportunity Funds. The program allows investors to defer, reduce, and possibly eliminate tax on capital gains.
How Do Opportunity Zones Work?
A qualified Opportunity Fund is a privately managed investment vehicle organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone businesses or property. Governors (or the Mayor in the case of the District of Columbia) may designate 25 percent of their state’s low-income census tracts as qualified opportunity zones, subject to certification by the U.S. Secretary of the Treasury.
To meet the definition of qualified Opportunity Zone businesses or property, the original use of the property MUST commence in the zone, or the property must be substantially improved. Additionally, the property must have been acquired by the Fund after December 31, 2017.
Investors may purchase qualified opportunity zone business stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property. Only taxpayers who roll over capital gains of non-zone assets before December 31, 2026, will be able to take advantage of the special treatment under the provision.
Tax Incentives Offered
There are three tax incentives for investing in low-income communities through a qualified Opportunity Fund.
The first incentive relates to temporary deferral of tax. Specifically, a taxpayer is allowed to temporarily defer the inclusion of income from capital gains reinvested within a tight timeframe into an Opportunity Fund.
Second, investors can get a step-up in basis for capital gains reinvested in an Opportunity Fund until the earlier of the date on which the investment is sold or exchanged, or December 31, 2026. The basis is increased if the gains are held by the zone at least 5 years and by an additional 5% if held for at least 7 years. This would allow the investors to exclude up to 15% of the original gain from taxation.
The third incentive permits investors a permanent exclusion from taxable income of capital gains over and above the original gains invested if held for at least 10 years. As stated, this exclusion only applies to gains accrued after an investment in an Opportunity Fund.
Update on Regulations
The second set of proposed regulations (REG-120186-18) issued in April clarified what is meant by “the original use of property.” The regulations state that the original use of the property does not begin until someone “places the property in service in the qualified opportunity zone for purposes of depreciation and amortization (or first uses the property in a manner that would allow depreciation or amortization if that person were the property’s owner).”
One twist in the regulations is related to the investment of section 1231 gains. Investors were anticipating the IRS might provide some relief on the investment of section 1231 gain, but the regulations only allow net section 1231 gains to be invested. However, investors who have already invested gains may receive some form of relief since the regulations have not yet been issued.
If you have questions regarding Opportunity Zones or other complex tax issues, please contact Steven Miller, alliantgroup, LP’s National Director of Tax, at StevenMiller@alliantgroup.com.