The genesis behind the Opportunity Zone legislation traces back to an unlikely cohort of bipartisan lawmakers, conservatives and young philanthropic multi-billionaires. The engine behind the idea was Sean Parker, of Napster fame, the original president of Facebook, who a decade earlier approached a few senators from the states with the largest concentration of run-down neighborhoods and highest inner-city poverty rates. From these beginnings, an ambitious project was born that, at least in theory, aims to direct over $100 billion of balance sheet profits into America’s almost 8,800 depressed and underperforming communities, designated by states as Qualified Opportunity Zones (“QOZ”), over the next few decades. All an investor needs to do is to theoretically invest money into a §1400Z Qualified Opportunity Fund (“QOF”) between now and December 31, 2028.
So how is this new law supposed to attract capital? The Opportunity Zone tax incentive is a combination of tax deferral and (legalized) tax avoidance. The three main principals driving the Investing in Opportunity Act are:
- Deferring of current capital gains tax
- Potential forgiveness of a portion of the current tax
- Tax-free growth of the O-Zone investment if held for a certain statutory period of time
Of course, the devil is always in the details, and every taxpayer’s situation and incentive will be significantly unique. Let’s study each principal individually.
Deferring Current Capital Gains
Being able to save on a current tax bill is usually the most persuasive argument when deciding whether to take advantage of a particular tax scheme. The deferral opportunity under the §1400Z section is very generous, in that you can roll over capital gain from any appreciated asset within 180 days of sale. And if the gain was realized within a partnership, an LLC or an S-corporation, of which you are a member or shareholder, you have 180 days from end of the tax year (i.e. June 29, 2019 in the case of 2018 gains) to reinvest into a QOF and avoid including that income on your tax return. And presuming you hold the QOF investment through end of 2026, you do not have to recognize that income until then.
To most high-net-worth taxpayers, this may sound like a great opportunity. And it is. But not everyone will get the same bang for their buck. For instance, some investors may already have capital loss carryforwards from previous years (or were able to harvest losses at the end of 2018). So they already are not paying capital gain and, depending on the magnitude of the carryover losses, may already be deferring capital gain taxes way into the future. Conversely, some states, like New Jersey or Pennsylvania, do not allow carryover capital losses. In those cases, there may be an advantage to utilizing the O-Zone deferral mechanism to avoid a large capital gain recognition even if the taxpayer has carryover losses from prior years.
Of note, the nature of the deferred gain will not change, so a rolled over short-term gain, while deferred and not currently taxable, will still retain its character as a short-term capital gain in the year of inclusion. However, this could present an opportunity for those investors who don’t have any losses today to offset an otherwise 37% short-term gain, but will be more flexible in future years and might have either short-term or long-term losses to offset the deferred gain in the year of recognition.
With any deferrals, one must exercise caution before assuming that the rate will be the same in eight or ten years from now. The law states that the character of the gain will be preserved until the time when it is finally includible on the tax return, but it does not guarantee that it will be taxed at the same rate as it would have been today. For instance, if an investor is in the 15% or 20% bracket today, it is quite possible that the tax rate might be higher in 2026, due to either a change in tax law by a future Congress, or a change in the investor’s tax bracket. The opposite is also true: if today’s capital gain (like in most cases) is subject to the “Obamacare” surcharge of 3.8% on top of the capital gain tax, but the surcharge is later repealed, it might result in a lower tax bill during the year the capital gain matures and is subject to taxation.
Reduction (Discount) of Capital Gains
Another attractive provision in the QOF law is the ability of taxpayers to not only defer, but slightly reduce, the rollover gains in some situations. While the technical language of the Internal Revenue Code refers to this principal as a “partial step-up in basis”, it technically acts as a partial reduction of the capital gain. The law provides for two separate discounts: 10% for investments held for five years, and another 5% if held for another two years. Said differently, early investors can reduce the tax bill by up to 15% if they hold the QOF investment for at least seven years.
Two very important observations relative to this tax benefit are worth mentioning. First, the 10% or 15% discounts are not synonymous with a reduction of the taxpayers’ bracket, which seems to be causing the biggest confusion among a large number of people. For an individual who would otherwise be in the 20% bracket, a five-year holding period will not reduce the tax rate to 10% of the gain, but rather translate into an 18% tax rate on the previously deferred gain (i.e. 10% discount on the 20% rate).
Second, the five- and seven-year windows to earn the two discounts close as of December 31, 2026. As such, the last chance to make an investment into a QOF and earn a 15% discount would be in December of 2019, while the opportunity to get a 10% discount will expire by late 2021.
Tax Forgiveness of Capital Growth
The largest tax saving potential for a QOF investment, evidenced by the marketing materials of most funds, is not paying any tax of the qualified investment after having held it for at least ten years. While this provision is the most restrictive (as it requires a “lock-in” of the investment for at least ten years), it is also the most appealing. As desirable as tax deferral might be, it serves to merely postpone the inevitable for a few years, i.e. a bill from the Tax Man. On the contrary, taking a disciplined approach to the QOF investment and keeping it intact for 10+ years would mean a complete tax forgiveness on the post-rollover appreciation portion, essentially making it a tax-free investment. As most states have conformed to the US Treasury on the treatment of Opportunity Zones as of today (Pennsylvania being one notable exception), potential tax savings could be significant. And the law allows investors to keep the investment beyond the ten-year mark if they so choose, with January 2048 as the maximum statutory threshold before which the investment should be liquidated.
Of course, with 30 years to go, it may very well be extended indefinitely. With that in mind, there are pitfalls that need to be understood and avoided. For instance, if the investor dies while holding an interest in a QOF but before the previously deferred gain is recognized, that gain does not become tax-free and instead will be considered IRD, or “income in respect of a decedent”, a fancy tax term that simply means that whomever inherits the interest in the QOF will have to pay capital gains tax on it. Compare that outcome with a regular investment, which would get a step-up in basis on death and permanently escape capital gain taxation on the gain realized at death.
Considering the above, it is no wonder that the O-Zones law has triggered a frenzy within the asset management community, as well as among law, accounting and real estate firms, who in recent months have generated hundreds of white papers and alerts praising the Opportunity Zones tax benefit. The initial reaction from seasoned investors was cautious, as there was not a lot of guidance on the mechanics of implementation of the law or clarity on how to structure entities from a tax perspective. Since the legislation was introduced, the Treasury Department has issued two sets of regulations and guidance. The first round in October 2018 allayed most concerns the potential funds had about meeting the strict qualification guidelines. The second round, issued just a few weeks ago, addressed taxpayer concerns raised by accountants and lawyers relative to refinancing and income distribution ramifications over the long term of the QOF investments. Both sets of regulations took taxpayer-friendly and fund-friendly approaches on most of the thorny aspects of the law that had been seen as impeding attractiveness of such investments. With most technical hurdles removed and rules promulgated, the questions related to these investments shifted from regulatory compliance to due diligence of various funds that advertise themselves as Qualified Opportunity Funds.
Considering the deadline of December 31, 2019 for most funds to have qualified for the full benefits of QOZ (including the 15% discount on deferred gains), some recent arrivals to the O-Zone scene might have looked to cut corners to qualify for self-certification of their compliance with the new rules. We urge utmost care when selecting a qualified investment vehicle to take advantage of this new tax opportunity.
In summary, Opportunity Zones might offer significant tax benefits but investors should carefully analyze various aspects of each program to make an informed decision on whether and how much to invest.