What are tax incentives with O-Zone investments?
By now, you may have heard of the federal opportunity zones (O-Zones) that were established by the 2017 federal tax overhaul. In their simplest form, the O-Zones are designed to incentivize taxpayers to invest in low-income areas of economic development. The original law as passed provided for some uncertainty surrounding the specific requirements for investing in O-Zones, which left many taxpayers wary of making such investments thus far.
A few weeks ago, U.S. Department of Treasury issued proposed regulations to help provide clarity into the requirements for establishing and operating qualified opportunity funds (QOF), which are investment vehicles created for the main purpose of reinvesting monies realized from certain gains into the designated O-Zones. Of course, there still are some questions that need to be answered, but let’s dig into what has been provided while we await further final guidance from the IRS.
O-Zones, what and where are they?
O-Zones are population census tracts that meet the definition of a low-income community and have been selected by each state’s government as an area for potential development. An official list of all census tracts that qualify as designated O-Zones for each state is provided in IRS Notice 2018-48. Additionally, an interactive map highlighting the selected areas can be found at the Treasury’s Community Development Financial Institutions Fund website (cdfifund.gov) under the Opportunity Zones Resource section.
Although it is not a requirement to invest in funds within the taxpayer’s or fund’s state, it is worth noting that there are many of these zones located in the West Michigan Region. Zones by county include: Allegan (1), Barry (1), Berrien (5), Calhoun (4), Ionia (1), Kalamazoo (5), Kent (10), Muskegon (5), Montcalm (2), Newaygo (1), Ottawa (1), and Van Buren (2).
There are essentially three tax advantages that the new law creates when investing in QOFs:
Temporary deferral: If certain gains are invested into a QOF within 180 days of being realized, the total gain invested can be deferred until Dec. 31, 2026, or until the new investment in the QOF is sold or disposed of, whichever is earlier.
Permanent exclusion of a portion of the deferred gain: If the taxpayer holds the QOF investment for at least five years, the deferred gain that originally was invested would be permanently reduced by 10 percent. If the taxpayer were to continue holding the investment an additional two years (seven years total), the amount of deferred gain would be further permanently reduced by another 5 percent (15 percent total).
Permanent exclusion of a portion of the deferred gain: In addition to the reductions on the deferred gain invested, if the investment in the QOF is held for at least 10 years, any post-acquisition gain on the appreciation of the investment will be permanently excluded from the total gain recognized when the investment is sold or disposed.
What clarifications do we have with the recently proposed regulations?
One of the more important areas requiring some clarity is determining what types of gains are eligible for the deferral. The proposed regulations provide that any gain that is treated as a capital gain for federal income tax purposes will be eligible for the deferral treatment. Therefore, short-term gains, long-term gains, 1231 gains from the sale of real estate used in a trade or business, and any unrecaptured 1250 gains will qualify. Certain depreciation recapture taxed as ordinary income will not qualify. The original attributes of the gain, such as short term versus long term, will carry forward when the gain is ultimately recognized. Certain gains from related parties also are not eligible for deferral.
Another important clarification is the type of taxpayers that are eligible to make the gain deferral election. The proposed regulations define an eligible taxpayer as any taxpayer that recognizes capital gains for federal tax purposes, which would include individuals, C corporations, partnerships, S corporations and trusts or estates. For pass-through entities, either the entity itself can make the election, or to the extent the entity does not make the election, the owners to whom the entity allocates the gain may make the election.
The time to make the QOF investment and election is within 180 days following the date that the capital gain would have been recognized for federal tax purposes. If an owner of a pass-through entity is making the election, the owner’s 180-day period does not begin until the last day of the entity’s taxable year in which the realization event occurred. As an alternative, the owner may elect to treat the owner’s own 180-day period as being the same as the entity’s 180-day period, providing some flexibility to pass-through entities.
A taxpayer is allowed to make multiple elections with respect to various parts of a gain from a single sale or exchange event. If both eligible gains and other funds are invested into a QOF, the tax benefits only apply to the portion of the funds originating from the eligible gain. Thus, proceeds in excess of the gain realized can be contributed to a QOF, but the tax advantages only apply to the gain portion. The proposed regulations provide for identification rules with respect to certain property that may be identical except for certain attributes such as basis and holding periods. The investment into the QOF must be an equity investment (debt does not qualify), but it includes preferred stock as well as a partnership interest with special allocations.
The proposed regulations also provide significant clarification into the requirements to establish a QOF, qualify as a QOF, self-certification and other requirements including asset tests and direct/indirect ownership issues. This guidance should spur the creation of many QOF investment vehicles.
Although the proposed regulations provide a significant amount of guidance on the opportunity zone provisions, there still appear to be open questions that will need to be addressed in additional guidance, such as any potential exception to the 180-day rule, tax treatment on gains that a QOF re-invests and various other definitional clarifications.
Overall, it appears that the IRS wants to encourage O-Zone transactions by allowing for some flexibility within the framework of the proposed regulations. Now that this additional guidance has been provided, it is expected that taxpayers will feel more comfortable moving forward with investments that qualify under these complex provisions. Taxpayers with an appetite for liquidating certain built-in capital gain assets in order to invest the gain into O-Zone investments, while achieving the tax benefits that these O-Zone investments provide, should work closely with their tax advisers in order to minimize risk and make well-informed, tax-efficient decisions.
Kelli Olson is a tax managing director and Eric Fischer is a tax senior manager with the local office of accounting firm BDO USA, LLP. The views expressed above are those of the authors and not necessarily those of BDO USA, LLP. The comments expressed above are general in nature and are not to be considered as any specific tax or accounting advice and cannot be relied upon for the purpose of avoiding penalties. Readers are urged to consult with their professional advisers before acting on any items discussed herein.