By David G. Angerbauer
As part of the Tax Cuts and Jobs Act, a new tax incentive program was created to encourage economic development in distressed communities. Within these communities, specific “qualified opportunity zones” or “opportunity zones” were designated by the governors of all 50 states. Utah has a total of 46 opportunity zones located in various metro and rural areas. These zones may be found at locate.utah.gov under the “Econ Development” tab.
To incentivize long-term investment in opportunity zones, the new tax program provides extraordinary tax benefits to those who invest in opportunity zones through investment vehicles called “qualified opportunity funds” or “opportunity funds.” These opportunity funds generally operate like other investment funds but with a mandate to invest in businesses located in opportunity zones. As expected, the new tax law places various requirements on how opportunity funds are formed and operated.
The tax benefits associated with opportunity fund investments are available to taxpayers who have “capital gain” money to invest (outside of IRAs and qualified retirement plans). Capital gains are generally created when a taxpayer sells appreciated property such as real estate, stocks, mutual funds and ETFs. Therefore, if you don’t have any recent or potential capital gain transactions, you won’t be eligible for the tax benefits associated with the new program.
If a taxpayer, including individuals and entities, has a capital gain transaction and invests all or a portion of the gains within 180 days in an opportunity fund, the taxpayer will be entitled to receive the following tax benefits: (i) deferral of the capital gain invested in the fund, (ii) reduction of 10% of the capital gain if the investment is held for 5 years (15% if the investment is held for 7 years), and (iii) exclusion of any appreciation or gain over the original invested amount if the investment is held for 10 years or longer.
For example, if a taxpayer sold appreciated property that generated a $100,000 capital gain and then invested that gain in an opportunity fund in 2019, the taxpayer would be able to defer paying taxes on the capital gain until December 31, 2026 (a fixed date set by Congress). If the taxpayer held the investment in the opportunity fund until such date, the taxpayer would only be taxed on $85,000 (reflecting the 15% reduction for 7 years). Most importantly, if the taxpayer held the investment for at least 10 years and, hypothetically, the original $100,000 investment appreciated to $500,000 – the taxpayer would not pay any tax on the $400,000 increase.
Because of this exceptional tax treatment, there has been a significant buzz and interest in opportunity funds. The new program that created opportunity zones and opportunity funds is codified in Sections 1400Z1 and 1400Z-2 of the Internal Revenue Code. In response to numerous questions related to these sections, the Treasury Department issued much anticipated guidance in the form of proposed regulations and a revenue ruling on October 19, 2018. Since then, the Treasury Department has not issued further guidance other than minor corrections to the proposed regulations (as of the date of this article). The Treasury Department has, however, promised additional guidance and rule-making that are expected in early 2019. Although many questions remain unanswered pending the release of further regulations, there is enough information and guidance available for enterprising investors and project managers.
Having already formed multiple opportunity funds in Utah involving real estate projects ranging from micro unit apartments to large scale commercial residential and lodging properties, it is important to note the following “lessons learned” to date: (i) although opportunity funds were designed to facilitate economic growth for a wide variety of early-stage and growth-oriented businesses in opportunity zones, the opportunity funds that have been formed and capitalized are investing primarily in commercial real estate development projects; (ii) most of these real estate projects are single asset developments and properties; (iii) the Treasury Department’s working capital safe harbor rule favors indirect investments in a “qualified opportunity zone business” rather than a direct investment in “qualified opportunity zone business property;” (iv) real estate developers may be able to achieve favorable tax treatment through special allocations in lieu of a portion of anticipated upside through a carried or promoted interest; and (v) it is prudent to plan and address the entire lifecycle of the fund and the proposed investments and exit strategies before structuring and forming the fund.
The process of forming and operating an opportunity fund involves numerous considerations, including a host of technical and complex tax and legal requirements. Notwithstanding these challenges, opportunity funds hold significant promise for economic growth in distressed communities. As more and more opportunity funds are established to invest in Utah’s 46 opportunity zones, our state will undoubtedly realize long-term economic effects while investors simultaneously receive unprecedented tax benefits.
DAVID G. ANGERBAUER
David is a shareholder at the law firm of Durham Jones & Pinegar and a leading practitioner in the field of opportunity zones and opportunity funds. He frequently speaks on these topics and, at the request of the Governor’s Office of Economic Development, has presented to the Governor’s Economic Development Council and at the Utah Economic Summit in St. George.