You may have heard of Opportunity Zones. But, like all things connected to taxes, it can be hard to figure out just what Opportunity Zones are and what actual opportunities they present. Qualified Opportunity Zones were created by the Tax Cuts and Jobs Act in 2017, and the IRS recently issued proposed regulations that give guidance on how the Zones will work.
Opportunity Zones are an economic development tool created to identify specific locations that are ripe for investment, and then give incentives to taxpayers to invest in those areas. Each state has designated Opportunity Zones by census tracts, which the IRS then certified. Minnesota’s list of Opportunity Zones is available at the Minnesota Department of Employment and Economic Development’s web site. A list of Opportunity Zones in Wisconsin is also available online.
The incentive for taxpayers comes in the form of delayed and reduced taxes. Taxpayers can defer paying taxes on capital gains until December 31, 2026, if they invest the gains in an Opportunity Zone and meet certain requirements. As an added incentive, if the investment is held long enough, the taxpayer may be able to avoid some future taxes when they sell the investment down the road. Specifically, if the taxpayer holds the investment for five years, ten percent of their deferred gains are excluded from taxes. If the investment is held for more than seven years, fifteen percent is excluded. And if the investment is held for at least ten years before it is sold, the taxpayer won’t be taxed on the appreciation of the initial investment.
How does this all work in practice? Consider the following example. A taxpayer has a $100,000 capital gain on December 3 1, 2019. The taxpayer invests that $100,000 in a fund that then invests in certain types of property. After five years, the taxpayer’s taxable gain is reduced to $90,000, and after seven years, it is reduced to $85,000. The deferred taxes are then due on December 31, 2026, but the taxpayer only pays taxes on $85,000 instead of $100,000. If the taxpayer waits until 11 years have passed and then sells its interest in the fund for $150,000, the taxpayer doesn’t pay any tax on the $50,000 gain on the initial investment. In the end, the taxpayer will have avoided paying taxes on a total of $65,000 dollars.
This example uses a large capital gain for a single investor. But, there’s no reason that a number of individuals or businesses with smaller capital gains can’t work together to take advantage of a project in a Qualified Opportunity Zone. Investors who can take advantage of this tax incentive can pool their resources by forming a Qualified Opportunity Zone Fund, as described below.
The mechanics underlying an investment in a Qualified Opportunity Zone are somewhat complicated. Here’s a high-level description of the basics.
The taxpayer must, of course, have a capital gain that can be invested in the Opportunity Zone. That gain has to come from an arms-length transaction with an unrelated party. In other words, the gain can’t come from a transaction between business affiliates or close family members.
The taxpayer then invests the capital gain in a Qualified Opportunity Zone Fund (a “Fund”). That’s a business specifically set up to invest in an Opportunity Zone for the purpose of obtaining the deferred tax treatment. The Fund has to be set up as a limited liability company, partnership, or corporation, and the taxpayer must have an ownership interest in the Fund.
The Fund must have 90% of its assets in what is known as Qualified Opportunity Zone Property (“Property”). The Property can take a few forms. It can be an ownership stake in a Qualified Opportunity Zone Business, which is just what it sounds like, a business that has the majority of its tangible property in an Opportunity Zone. The business can’t be a golf course, country club, or liquor store, among other requirements. The Property can also be a building, as long as it is either new construction or a very substantial rehabilitation of an existing building that was acquired after December 31, 2017. If the building is being rehabilitated, the business will need to spend as much on the rehabilitation as it did to buy the building.
There are very rigid requirements to obtain the tax treatment offered by Qualified Opportunity Zones. The taxpayer must invest in the Fund within 180 days of receiving the gain. The Fund must be able to demonstrate six months after it is formed, at the end of its first tax year, and again in the future that it has 90% of its property invested in a Qualified Opportunity Zone. If the Fund owns a Qualified Opportunity Zone Business, that business must have 70% of the tangible property it owns or leases in the Opportunity Zone. The business must also receive half of its gross income from actively conducting a trade or business in the Opportunity Zone. The proposed regulations from the IRS contain a number of safe harbors that should make it easier to know if a business can satisfy these requirements. This represents only a very short list of many different requirements.
Individuals and businesses can obtain tremendous advantages by taking advantage of Qualified Opportunity Zones. Communities with Opportunity Zones in their borders can also leverage the tax credit by encouraging investments in an Opportunity Zone. The requirement for buildings to be either new construction or very substantial rehabilitation means that investments in Qualified Opportunity Zones will tend to be noticeable and lasting. New construction or substantially renovated buildings could result in increased tax revenue, or accomplishing other goals, such as increasing housing inventory or employment.
This article has only provided a very brief overview of Qualified Opportunity Zones and how they work. Anyone intending to invest in an Opportunity Zone should seek help from an accountant and an attorney due to the long-term tax and business planning required to take advantage of the Opportunity Zone program.
John Gasele is an attorney at the Fryberger Law Firm in Duluth, practicing in the areas of corporate, utility, Internet, trademark, and copyright law. You can reach him in the firm’s Duluth office at 218-722-0861.