The Land of OZ

7 min read

Opportunity Zones: benefits and open questions 

Much of the excitement associated with the 2017 Tax Act was due to the large corporate tax cuts. Far less notice was accorded new sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code: They provide a broad incentive based on the concept of “qualified Opportunity Zones.” Opportunity Zones are essentially a subset of the “low-income communities (LICs)” associated with the New Markets Tax Credit.  Approximately one in four LICs have been designated as Qualified Opportunity Zones (QOZs), and the new provisions are intended to encourage investment in these QOZs by providing substantial tax deferrals and savings.

Under the new provisions, an exceptional tax break is provided when, within 180 days of realizing capital gains, and possibly other gains, a taxpayer invests an amount equal to these gains in an “opportunity fund,” essentially a fund holding one or more active trades or businesses that consist of either property, or partnership interests or stock of entities doing business in Opportunity Zones.  Note that this is a much easier requirement than applies to like-kind exchanges; the amount invested is just the gain, not the proceeds, no intermediary to hold the funds is required, and the fund interest acquired needn’t bear any similarity to the property sold. For example, an investor could sell corporate stock and then invest a corresponding amount of borrowed money in an opportunity fund that was classified as a partnership and invested in real estate.

There are four benefits from investing in an opportunity fund:

  • First, payment of the tax that would otherwise be due on the invested gain is postponed until December 31, 2026, or the date that the interest in the opportunity fund is disposed of, if earlier.
  • Second, although the investor’s basis in its newly acquired interest in the fund is zero at the time of the investment, that basis is increased by ten percent of the deferred gain if the investment is held for at least five years, and another five percent if the investment is held seven years. These two adjustments effectively reduce the investor’s tax liability by a total of 15 percent.
  • Third, the taxable gain will also be reduced if the value of the investor’s interest in the fund has declined in value when the gain would otherwise be recognized.
  • Finally, if the investor holds its interest for at least ten years, the basis in the interest is increased to its fair market value at the time of disposition. In general, this should wipe out possible tax on any appreciation beyond the amount that was originally taxed.

For example, suppose A sells $5 million of stock with a basis of $2 million, yielding a $3 million gain in 2018.  Within 180 days, she invests $3 million in an opportunity fund, and holds her interest in the fund until 2033 (15 years), when she sells the interest for $8 million. On those facts, she will not pay tax in 2018, she will most likely pay tax on $2.7 million (i.e., $3 million less 15 percent) at the end of 2026, and she won’t pay any tax when she sells the interest in 2033, even though she would otherwise have a far smaller basis ($3 million, as adjusted for profits and losses allocated to her by the fund) at that time.

Open Questions
The description provided here is brief and generalized. Unfortunately, it is hard to provide something with greater specifics because the rules are both a mix of imperfectly defined technical terms and imprecise and inaccurate statute writing that make it hard to have greater confidence in how the rules will work. On account of these problems, the IRS is hard at work on providing guidance, which has so far consisted of just a handful of frequently asked questions, or “FAQs.”

In a meeting with the Treasury, we had the opportunity to ask about their plans and offer suggestions.

The most fundamental request from the government is that the investment community highlight the issues that were preventing deals from closing. With that in mind, we highlighted several issues:

  • When a capital gain accrues to a pass-through entity (e.g., a partnership or LLC), should it or its partners/members do the investing? If the latter, how should they determine their share of the gain, and when does the 180-day clock start running?
  • Can an LLC under state law, which is then treated as a partnership or corporation under tax law, qualify as an opportunity fund under the Tax Code, which refers to entities “formed” as partnerships or corporations?
  • Will gains other than capital gains, such as so-called 1231 gains from the sale of trade or business property, gains on sales of debt instruments that are denied capital gains treatment by section 582(c), and depreciation recapture, normally an exception from capital gain treatment, qualify for favorable treatment?
  • What is the role of borrowing? Are there any limitations on a fund borrowing money to build or refinance a project? If a fund borrows money and makes a distribution to its members, are they still holding the same interest as before?
  • What are the consequences of running a trade or business through an opportunity fund formed as a partnership? Do investors simply get K-1s and report their share of profits and losses, like a non-Opportunity Zone business?

The Toughest Hurdle
The toughest hurdle so far has been determining what rules apply to property with a long construction or rehabilitation period. Do such activities constitute an active trade or business, as is required by the Code section? Furthermore, the statute requires that if the fund holds used property, an amount equal to the taxpayer’s basis in the used property must be spent with respect to the property during a 30-month period after acquisition.  Does this mean that a fund has 30 months to complete a rehabilitation project? And what about new construction? No timetable or period is specified for new work.  Moreover, note that the obligation to match basis in used property with new spending is far larger than the section 42 requirement for redeveloping existing housing. Will this cause potential Opportunity Zone investors who want to make Low Income Housing Tax Credit investments prefer new construction?

Treasury Responses
In speaking with Treasury about these and other open questions, we noted a few consistent responses:

First, we got little in the way of actual indicators of where the coming guidance might be headed. Treasury is very much in a “You tell us what matters” mode, and not a “We will tell you how to do it” one.

Second, a common response to questions was, “Tell us exactly which provision of the Internal Revenue Code makes you worry about the answer to your question.” In many ways, this is a favorable response, because it suggests that taxpayers should not go hunting for problems with overly pessimistic interpretations of the new law.

And, third, was the sense that the community would do a certain amount of self-policing, “like the LIHTC community.” This last observation could prove important, because the Opportunity Zone code sections contain errors and odd references (to non-existent subsections, for example) and the government seems to be counting on some help from the investor community.

Hopefully, the IRS guidance will be produced quickly and facilitate investment. In the meantime, we may see investors with large capital gains and an appetite for 15-year LIHTC investments taking their chances with intelligent guesses at the rules. If they guess right in their interpretations of the new law, then they will get the benefit of a time-value-of-money savings in paying their taxes and maybe more. And if they guess wrong, well, they planned to both pay their taxes and make the housing investment anyway.