Opportunity Zones

May 17, 2019

The Basics, Recent Developments & Expectations

By David R. Koehler, CPA

Opportunity zones were made into law with the Tax Cuts and Jobs Act (TCJA) of 2017 and are designed as an economic development tool to encourage long-term investment and job creation in low-income communities throughout the country. The biggest headline-grabbing feature is the ability for taxpayers to defer gain recognition until 2026 and potentially eliminate up to 15 percent of initial gain. 

This article is targeted to give CPAs the tax basics surrounding opportunity zones, updates on recent developments and explore where taxpayers and their financial advisers may see “opportunities” in this area.

The Basics
The initial incentive to invest in a Qualified Opportunity Fund or Qualified Opportunity Business is certainly the initial tax deferral on a realized capital gain. This incentive is compounded by the 10 percent to 15 percent gain elimination on the original investment, given the proper holding periods. Another attractive feature is the availability of complete gain exclusion on the appreciation of the new opportunity zone investment after a 10-year holding period. Yes, the entire gain on the new investment is federally tax-free if held for 10 years.

IRS Code Sec. 1400Z, amended by the TCJA, allows a taxpayer to elect to defer a realized capital gain in the current year and defer all federal tax on the invested gain until Dec. 31, 2026. IRS Form 8949 is used to make this election. A taxpayer has 180 days from the realization of a gain to make a qualified investment in an opportunity zone and qualify for tax deferral. 

The law states that until Dec. 31, 2026, if the investor-holding period of the new investment exceeds five years, 10 percent of the initial gain is exempt from federal tax. After a seven-year hold an additional 5 percent of original gain is tax-free. The payment of the remaining capital gain tax, as well as the 10 percent or 15 percent gain exemptions, give taxpayer basis in the investment. 

It’s important to emphasize that the remaining original gain deferred at time of investment (85 percent to 100 percent) becomes taxable in 2026. Taxpayers and their advisers need to plan accordingly to pay this additional tax assuming the initial gain funds are still invested in the opportunity zone fund or business.

Since the signing of the tax law in late 2017, the IRS has moved steadily toward providing more guidance and clarity on the specifics of the code section. By June 14, 2018, the IRS certified 8,762 low-income community census tracks spread between all 50 states, District of Columbia and five territories. For details on the designated communities, refer to IRS Notice 2018-48 and online maps where you can zoom into designated areas. Visit PolicyMap online to analyze and drill down to various data layers, including an opportunity zone filter.

Another Round of Regs
In October the IRS issued proposed regulations (REG-115420-18), followed by a February hearing. The IRS then issued another round of proposed regulations on April 17 (REG-120186-18). This second round of proposed regulations clarified many questions, such as definitions of terms and details surrounding entity and business qualification issues. 

Rules for Qualified Opportunity Funds are similar to state tax apportionment rules where asset, payroll or income factors help determine if a business qualifies for the gain elimination. 

For example, 90 percent of the tangible assets of the fund must be located in an opportunity zone, as well as 50 percent of the services provided and income generated. 

These “safe harbors” give investors confidence that their gain will qualify for the initial exclusion and tax-free growth after the 10-year holding period. A Qualified Opportunity Fund must file a Form 8996 with its federal income tax return for annual reporting of compliance with the 90 percent Asset Test. Qualified Opportunity Businesses have similar qualification safe harbors, such as at least 50 percent of total wages or hours of employees and independent contractors are performed within and opportunity zone. 

Another safe harbor for a Qualified Opportunity Business is if 50 percent or greater of the tangible property of the business and 50 percent of the management and operational functions are performed inside the opportunity zone. A good example of a potential business that seems tailored to open in an opportunity zone is a local small tax practice serving the community. 

Conformity Questions
Opportunity zones are only a federal issue, but some states are considering limited conformity, likely to promote state or community specific agendas. Specifically, the primary focus by local communities and states appears to be on providing incentives to build new quality low-income housing. A major focus of the Opportunity Zone Investor Summit in March was on how to empower city and communities to attract investments and investors. 

As reported by the San Francisco Chronicle, Gov. Gavin Newsom says, “Opportunity zone programs could help address two of the state’s major challenges: promoting energy investment to meet its climate change goals and providing funding for housing amid a shortage that has exacerbated income inequality.” 

In California, cities such as Oakland are promoting themselves as targeted investment areas and the Los Angeles Times reported, to date, 68 housing projects comprising some 4,200 units are under construction within these opportunity zones, and an additional 230 multifamily projects have been proposed.

The CPA’s Perspective
As a CPA financial planner, my initial interest in opportunity zones was the opportunity for my clients to potentially diversify out of concentrated equity positions and defer large gains until 2026. 

My expectation was the investment community would build programs that could capitalize on this new tax law. This is happening at all levels. Specifically, large institutional real estate development companies and capital sponsors that traditionally build Real Estate Investment Trusts (REITs) or provide securitized 1031 exchange programs are developing, rolling out or offering programs. 

Institutional companies have announced targeted opportunity zone funds with capital raise goals of $3 billion to $5 billion. Their focus is on large development projects, larger institutional investors or high net worth individuals. The REIT or 1031 exchange sponsors generally have a focus on smaller programs and capital raises. They range anywhere from $25 million to $100 million for 1031 Tenant-in-Common or Delaware Statutory Trust programs, to $250 million to $1.5 billion for the larger REIT programs. 

I expect a lot of continued hype in the investor fundraising area for opportunity zones and an increase in investor funds raised since institutional real estate sponsors have track records of successfully attracting investor capital to real estate programs. While not all real estate programs are successful, many provide reasonable cash flow yield while appreciating over time. Opportunity zones leverage the advantages of real estate investing, such as income deferral, through depreciation deductions. No one should ever chase a tax savings strategy by making a bad investment, but opportunity zones provide financial incentives to invest capital in worthwhile business or real estate ventures.

While there has been a lot of excitement and talk in the various industries that see benefits from opportunity zones, the actual real estate investment programs available to investors are still nascent, but growing rapidly. Finding applicable properties inside opportunity zones that make economic sense is a time-consuming process. As with any investment, extensive due diligence is advised. 

Active businesses started in opportunity zones should focus on becoming a successful enterprise first and view the accruing tax benefits as a bonus. Certainly, detailed technical questions remain, but investors and entrepreneurs are moving boldly forward. The potential addition of state conformity is an exciting and developing issue. I expect to see a lot of continued interest in opportunity zones. 

If you are a tax professional, financial planner or an investor, understanding this new tax law allowing for gain deferral and potential elimination should serve you and your clients well. 
David R. Koehler, CPA/PFS/CFP is the managing partner of Koehler & Associates, CPAs in San Jose, maintains an active financial planning business and is chair of the CalCPA Personal Financial Planning Committee.

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