By Jeff Thomas
The U.S. Congress’ right to impose the federal income tax was established when the 16th Amendment to the Constitution was ratified on February 3, 1913. Since then, many new federal tax laws have been enacted for economic, social, or political reasons. Some tax laws raise tax rates and some offer tax credits, while others are meant to provide support for a candidate’s re-election. Over the years, many new tax laws have been met with discontent, nonsupport, and a push to have the new law modified or overturned. Such is not the case with the Opportunity Zone Program included in the Tax Cuts and Jobs Act of 2017. Since it began on January 1, 2018, the Opportunity Zone Program has been very well received, as it provides both business owners and investors the ability to achieve substantial federal tax savings.
The stated goal of the Opportunity Zone Program is the use of capital gains realized by business owners and investors to revitalize certain lower income communities. Congress estimated that at the end of 2017 there were at least $2 trillion of unrealized capital gains that could be used for the Opportunity Zone Program. The program allows capital gains to be invested in businesses in one or more of an estimated 8,700 designated Opportunity Zones, offering taxpayers temporary and permanent tax deferral as a reward for helping to revitalize economically challenged communities. This is truly a win-win proposition.
Opportunity Zone Program basics
Businesses located within an Opportunity Zone will be funded with an equity investment from a self-certified entity known as a Qualified Opportunity Fund. Qualified Opportunity Funds are derived via the investment of capital gains generated by a proprietor, friends and family, or other outside investors. Realized capital gains must generally be invested in a Qualified Opportunity Fund within 180 days; however, additional flexibility exists for gains passed through from flow-through entities, including partnerships, and certain gains from the sale of assets used in a business.
Gains eligible for investment
All long-term and short-term gains are eligible to be reinvested in a Qualified Opportunity Fund. This includes gains from the sale of investments (stocks, bonds, and/or real estate), the sale of business assets, and the sale of a personal residence, art, automobile, and other personal property. The eligible Qualified Opportunity Fund must be a domestic entity classified as a corporation or partnership for tax purposes. It must be formed for the purpose of investing in an Opportunity Zone business. The Qualified Opportunity Fund must self-certify using IRS Form 8996.
A beneficial example
Jane Bizowner sold her business on June 1, 2019, for $150,000. Jane’s tax basis in her business was $50,000, so Jane realized a capital gain of $100,000. Jane could simply include the capital gain in her 2019 taxable income and pay federal and state tax on the gain on or before April 15, 2020. However, if Jane invests the $100,000 capital gain in a Qualified Opportunity Fund within 180 days of June 1, she can enjoy the benefits offered by the Opportunity Zone Program. Joan gets to keep, on a tax-free basis, the $50,000 of cash that equals her tax basis in her business. Joan can then elect on her 2019 federal tax return to defer the tax on the gain for up to seven years. The Qualified Opportunity Fund into which Jane invests her $100,000 capital gain will make an equity investment in a business located in a Qualified Opportunity Zone.
After five years, Jane will receive a 10% ($10,000) step-up in basis, reducing her taxable gain to $90,000. The tax on the gain remains deferred. After another two years, Jane will receive an additional 5% ($5,000) step-up in basis, reducing her taxable gain to $85,000. On December 31, 2026, the deferred tax on the reduced taxable gain of $85,000 is due and is payable on April 15, 2027. Jane has achieved a seven-year deferral and a reduced tax on her original $100,000 capital gain. And now for the really good news …
No federal tax on Fund investment
If Jane does not dispose of her investment in the Qualified Opportunity Fund for at least 10 years and then sells it for a gain, there will be no federal and possibly no state tax on the gain. The appreciation on Jane’s interest in the Qualified Opportunity Fund permanently escapes federal and possibly state taxation. Just think: If Jane invests in the next Microsoft or Google, she would save millions in taxes. To take full advantage of the Opportunity Zone Program’s tax benefits, investments of realized capital gains into Qualified Opportunity Funds should be made by December 31, 2019. However, the Opportunity Zone Program is not scheduled to terminate until the end of 2047. Therefore, investments made by December 31, 2037 are eligible to be disposed of on a no-tax basis.
A golden opportunity for businesses
The Opportunity Zone Program offers new businesses located in an Opportunity Zone the ability to be funded with tax-deferred equity dollars. The owners of the new business also will gain the possibility of tax-free appreciation after 10 years.
Pre-existing businesses can form new companies (subsidiaries/affiliates) and locate them in Opportunity Zones. The new companies can then meet the Opportunity Zone requirements and take advantage of the available tax-deferred and tax-free benefits.
If a business buys property in an Opportunity Zone and that property had been previously placed in service, then the business must invest 100% of the existing basis in improvements over a 30-month period. No reinvestment is necessary if the property was vacant for five years or if the property is leased. Leasing space in properties that were previously placed in service and are located in an Opportunity Zone is a very good way for an Opportunity Zone business to avoid having to make substantial investments in its Opportunity Zone property.
The fine print
A qualified Opportunity Fund must hold at least 90% of its assets in Qualified Opportunity Zone property. This includes certain stock or partnership interests of the underlying business and/or business property (personal and/or real property) of a Qualified Opportunity Zone business. Testing for the 90% threshold is performed every six months.
Substantially all of the tangible property owned or leased by an Opportunity Zone business must be Qualified Opportunity Zone property, located in the Opportunity Zone. Proposed U.S. Treasury regulations define substantially as 70% or more. At least 50% of the gross income must be derived from the active conduct of the business within the Qualified Opportunity Zone. Proposed Treasury regulations are available to guide an Opportunity Zone business owner and enable them to meet the requirements of the 70% and 50% tests.
A bright future
Billions of capital gains have already been invested in Qualified Opportunity Funds. Real estate and business deals are closing quickly in many Opportunity Zones. At first blush, it appears that the Opportunity Zone Program will be a success and many blighted areas will be returning to their former glory. Additional taxpayer-friendly Treasury regulations are expected by year’s end and these should make the program even more beneficial.
Disclaimer: The information presented here has been prepared for general guidance on matters of interest only and does not constitute professional advice. You should not act upon the information presented here without obtaining specific professional advice. No representation or warranty is given as to the accuracy or completeness of the information. You should also be aware that additional Treasury regulations are due to be released to further clarify the Opportunity Zone Program provisions of the Internal Revenue Code.
Amerimar Enterprises, Inc.
Jeff Thomas is Tax Director of Amerimar Enterprises, Inc. where he oversees the tax compliance and tax planning functions. Jeff relies on 40 years of comprehensive tax experience to resolve complex issues. Jeff has held key tax partnership or management positions for a Big Four accounting firm, multi-national real estate and energy companies, and large regional and local accounting firms. Jeff, a CPA, received his Bachelor of Business Administration in Accounting from Temple University’s Fox School of Business. Please reach Jeff at (215) 893-6083.
Featured in Commercial Real Estate Review – Third Quarter 2019