The Tax Cuts and Jobs Act created a novel new federal motivation for entrepreneurs to invest private capital into low-income, undercapitalized communities. Labeled “Opportunity Zones,” these communities were identified by state governors based on economic data from the 2010 Census and designated by the United States Treasury Department and Internal Revenue Service as areas in which corporations and individuals might receive tax incentives for investing qualified capital gains.
Since their creation, these Opportunity Zones have been lauded as having the potential to move massive amounts of capital into communities that have historically received little to no outside investment and criticized as an avenue for outside investors to dump money into investment black holes. Unfortunately, as happens so often with nascent programs, the regulatory language and anecdotal history is so sparse that both of these things can be true. The key to ensuring that Opportunity Zones are characterized in a positive way, then, is to ensure that participant investors are adequately informed.
That begins with a foundational understanding of how Opportunity Zones work. Essentially, the business entities and individuals looking to invest in these communities must first forming a Qualified Opportunity Fund (each, a “QOF”). These companies can be structured as a partnership, limited liability company, or corporation for the express purpose of investing in businesses located in Qualified Opportunity Zones. Importantly, any investors hoping to receive QOZ tax incentives via a QOF must do so by investing capital gain. While other kinds of capital may be invested into a QOF, that capital will never be considered for the same tax incentives as capital gains.
These QOFs must then invest directly in businesses or real estate residing in QOZs. Otherwise known as Qualified Opportunity Zone Businesses (each, a “QOZB”), these entities can either predate the QOZ program or, importantly, be founded by the QOFs in these undercapitalized communities. Either way, the investments in these QOZBs must result in “substantial improvements” to the business or the property within thirty (30) months of the initial investment. Additionally, in order to maintain their tax incentive eligibility, QOFs must hold at least ninety percent (90%) of their assets in QOZBs.
The tax incentives for QOZ investments can be significant. First of all, any capital gains invested into a QOF – and, in turn, a QOZB – are eligible for tax deferment. What’s more, if the QOF maintains its investment in a QOZB for five years or longer, it will be eligible to receive a ten percent (10%) reduction in taxation on the invested capital gain. If the investment is held for seven (7) or more years, it will be eligible for a fifteen (15%) reduction. If you hold the QOF investment for ten years, you can reduce capital gains by 15% in the seventh year and exclude any capital gains from the QOF investment when you sell. The only condition is that the investor must sell the QOF before December 31, 2047. And, if held for ten years or longer, the investment will not owe any federal income taxes on the fund’s appreciation. Originally, such investments were limited to 180 days from the realization of the original gain (the Investment Period). Subsequently, the IRS has extended the 180-day window to December 31, 2020 for any Investment Period that would have otherwise ended between April 1 and December 30.
Now, the IRS and the United States Treasury Department are still refining and sharpening the regulatory rules surrounding QOZs. That means the landscape of QOZ investments, and their associated taxation consequences, will be constantly evolving over the next several years. It is imperative, then, that you navigate these QOZ waters with experienced and knowledgeable professionals who will help you both interpret the ever-evolving tax regulations while also authoring the governance documents to ensure consistent compliance with the foundational requirements of the program.