HIGHLIGHTS:
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Part 1 and Part 2 of this series of Holland & Knight alerts described a new tax incentive contained in the Tax Cuts and Jobs Act for investments in low-income communities designated as "Opportunity Zones."
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In Part 3, we discuss the benefits for investing taxpayers, namely the deferral or partial exclusion of gain from the sale or exchange of an asset by a taxpayer who invests in a Qualified Opportunity Fund, as well as the potential exclusion of gain from disposition of an investment in an Opportunity Fund.
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Part 3 also highlights recently issued guidance on nominating census tracts as Opportunity Zones and recently enacted legislation providing for the automatic treatment of all low-income census tracts in Puerto Rico as Opportunity Zones.
Part 1 and Part 2 of this series of Holland & Knight alerts described a new tax incentive contained in the Tax Cuts and Jobs Act (the Act) for investments in low-income communities designated as "Opportunity Zones." The Opportunity Zone incentive and related rules are now codified in Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code.
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Part 1 of this series set forth the process for nomination by state governors and designation of Opportunity Zones by the U.S. Department of the Treasury.
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Part 2 focused on the requirements for formation and certification of an Opportunity Fund and the rules governing its operations.
In this third and final alert in the series (Part 3), we discuss the benefits for investing taxpayers, namely the deferral or partial exclusion of gain from the sale or exchange of an asset by a taxpayer who invests in a Qualified Opportunity Fund1 (Opportunity Fund), as well as the potential exclusion of gain from disposition of an investment in an Opportunity Fund (Opportunity Fund Investment). Part 3 also highlights recently issued guidance on nominating census tracts as Opportunity Zones2 and recently enacted legislation providing for the automatic treatment of all low-income census tracts in Puerto Rico as Opportunity Zones.
Deferral of Gain from Sale or Exchange of Property to the Extent of Investment in Opportunity Fund
Pursuant to Section 1400Z-2, a taxpayer who would recognize gain3 from the sale to, or exchange with, an unrelated person4 of any property held by the taxpayer may elect5 to defer recognition of the gain to the extent of the aggregate amount invested in an Opportunity Fund during the 180-day period beginning on the date of the sale or exchange.
No election to defer gain can be made 1) after Dec. 31, 2026, or 2) if an election previously made with respect to such sale or exchange is in effect. The latter rule may affect installment sales, an investment in an Opportunity Fund equal to less than all of the potential gain from a sale or exchange of property followed by a further investment in an Opportunity Fund, or even simultaneous investments in two Opportunity Funds.
Except for a potential partial exclusion described below, the deferred gain (Deferred Gain) is included in the taxpayer's gross income on the earlier of 1) the date on which the Opportunity Fund Investment is sold or exchanged, or 2) Dec. 31, 2026 (the Recognition Date).
The amount of gain included in gross income on the Recognition Date is equal to the excess of A) the lesser of 1) the Deferred Gain or 2) the fair market value of the Opportunity Fund Investment over B) the taxpayer's basis in the Opportunity Fund Investment. Except for the adjustments arising from the step-up in basis after certain holding periods described below, the taxpayer's basis in the Opportunity Fund Investment is generally deemed to be zero.6 For example, if the Deferred Gain is $100 and the fair market value of the Opportunity Fund Investment declines from $100 to $80 on the Recognition Date, the amount required to be included in income on that date would be the lesser of the two amounts (i.e., $80, not $100).
Because of the zero basis rule, it appears that a taxpayer may be unlikely to recognize a loss on the sale of the Opportunity Fund Investment unless it holds the investment long enough to qualify for the basis increase in years five and seven described in the next section. Moreover, the zero basis rule will affect the tax attributes of the Opportunity Fund Investment during its holding period. For example, if an Opportunity Fund is a partnership operating a trade or business that owns tangible property, it appears that depreciation deductions allocated to the partner that owns the Opportunity Fund Investment would not be recognized because it would have no basis in its interest in the Opportunity Fund.7 It is unclear whether liabilities would increase the basis of an Opportunity Fund Investment if the Opportunity Fund were a partnership.
Partial Step-Up in Basis of Opportunity Zone Investment if Holding Period Equals or Exceeds Five Years
Notwithstanding the zero basis starting point, if the Opportunity Zone Investment is held for at least five years, the basis of such investment is increased by an amount equal to 10 percent of the Deferred Gain. If the Opportunity Zone Investment is held for at least seven years, the basis in the investment is increased by an additional 5 percent of the Deferred Gain. If the investment has not been sold by Dec. 31, 2026, the remaining 85 percent of the Deferred Gain must be recognized and, due to the partial step up and gain recognition on the Recognition Date, the basis of the investment is correspondingly increased to 100 percent of the Deferred Gain. The law does not make clear whether the character of the gain recognized is the same as it would have been if the Deferred Gain was recognized at the time of the original sale or exchange.
If the property is held for more than seven years, the above provisions result in an exclusion from income of an aggregate of 15 percent of the Deferred Gain and a deferral of the remaining 85 percent of the deferred gain until Dec. 31, 2026 (unless sold earlier), when 85 percent of the Deferred Gain must be recognized.
Election to Exclude Gain on Opportunity Fund Investment Held at Least 10 Years
If the Opportunity Fund Investment is held for at least 10 years, a second election8 may be made to increase the basis of the Opportunity Fund Investment to the fair market value of the investment on the date it is sold or exchanged.9 This will have the effect of excluding from gross income any gain on the Opportunity Fund Investment in excess of the amount of any Deferred Gain recognized on Dec. 31, 2026.10 Because the Recognition Date for Deferred Gain is set before the expiration of 10 years from the earliest possible Opportunity Fund Investment, Deferred Gain can never be fully excluded from income.
Example: Assume that a taxpayer sells stock on Aug. 1, 2018, at a taxable gain of $1 million. She would owe $238,000 in tax on the gain for the 2018 tax year. However, if she invests $1 million in an Opportunity Fund in 2018, makes the applicable deferral election and holds the investment until Dec. 31, 2026, she would pay tax on $850,000 of taxable gain (85 percent of $1 million) or $202,300 for the year 2026.11 In addition, if she holds the Opportunity Zone Investment for 10 years (in this case, 2028) and makes the applicable second election, then sells it for $2 million, the basis in the investment would be increased to $2 million and there would be no tax on the $1 million of post-deferral gain.
In this scenario, the taxpayer enjoys all of the taxpayer-favorable rules discussed above: the deferral of gain, the partial step-up in basis and the second election to exclude gain.
Investments with Mixed Funds
As noted in Part 2 of this alert series, a special rule applies to investments with "mixed funds." Section 1400Z-2(e) states that in the case of an Opportunity Fund Investment, only a portion of which consists of investments of gain to which an election under Section 1400Z-2 (a) is in effect, the investment will be treated as two separate investments. One investment will include only the amounts to which a deferral election under subsection (a) applies (the "Deferred Gain Investment"), and any amounts to which an election does not apply will be treated as a separate investment. The deferral, recognition and gain exclusion provisions of Section 1400Z-2(a), (b) and (c) will only apply to the Deferred Gain Investment. The separate treatment suggests that, in the case of an Opportunity Fund structured as a partnership, any partnership liabilities will be allocated to the separate investment and not to the Opportunity Fund Investment.
Recent Developments
Revenue Procedure 2018-16
On Feb. 8, 2018, the Internal Revenue Service (IRS) published Revenue Procedure 2018-16 to provide guidance regarding the nomination of qualified low-income census tracts as Opportunity Zones. The guidance confirms that nominations are due no later than March 21, 2018, unless a 30-day extension is requested. Clarification regarding the calculation of the number of qualifying census tracts and contiguous tracts that can be nominated in each state, as well as how to determine if a tract qualifies, is provided. The guidance contains a link to an Opportunity Zones online resource (the Information Resource) for determining qualifying census tracts. Notably, the guidance confirms that the Information Resource is a "safe harbor," so that if a census tract is listed as an eligible low-income community or an eligible non-low-income community contiguous tract, a governor's nomination of the tract will not fail to be certified on the grounds that the tract is not eligible under more recent census data. Likewise, if a tract does not appear on the Information Resource, it may still be certified if supporting five-year data from the 2011-2015 American Community Survey (ACS) from the U.S. Census Bureau is provided. Finally, Rev. Proc. 2018-16 states that details on the nomination procedure itself, including an online nomination tool, will be provided individually to all state governors or chief executive officers.
Puerto Rico's Low-Income Census Tracts Automatically Qualify
Section 4115 of the Bipartisan Budget Act of 2018, signed by President Donald Trump on Feb. 9, 2018, amends Section 1400Z-1 to provide that every low-income community census tract in Puerto Rico is designated and certified as an Opportunity Zone.
Conclusion and Considerations
Regulations and other guidance are needed to fully elucidate the potential of the Opportunity Zone incentive. In the meantime, based on the statutory language, the gain deferral appears to be a somewhat shallow subsidy, but the gain exclusion on post-deferral appreciation for property held for at least 10 years may be a powerful incentive. Moreover, the Opportunity Zone incentive can be easily combined with other incentives for investment in distressed communities, such as the New Markets Tax Credit (NMTC), Low-Income Housing Tax Credit (LIHTC) and historic rehabilitation tax credit, adding a valuable tool for economic and community development.
Notes
1 A qualified Opportunity Fund is defined in Section 1400Z-2(d)(1) as any investment vehicle organized as a corporation or a partnership for the purpose of investing in "qualified opportunity zone property" and that holds at least 90 percent of its assets in "qualified opportunity zone property." Part 2 of this alert series describes in detail the requirements for formation, certification and operation of an Opportunity Fund.
2Revenue Procedure 2018-16
3 Although some of the legislative history refers to capital gain, as does the title of Section 1400Z-2, the operative provisions of the law do not limit the type of gain to which the provision applies. This may be clarified in forthcoming guidance.
4 For purposes of Section 1400Z-2, persons are related to each other if such persons are described in Section 267(b) or Section 707(b)(1), but substituting "20 percent" for "50 percent" in each such place it occurs in such sections.
5 Guidance about how and when to make this election will need to be developed by the U.S. Department of the Treasury.
6 Because the taxpayer's basis in the Opportunity Fund Investment is deemed to be zero, it appears that the taxpayer's starting capital account would also be zero, assuming the rule applies for all purposes. This could affect, among other things, partnership allocations in an Opportunity Fund structured as a partnership.
7 The result would be different if the Opportunity Fund is structured as a corporation that does not pass through tax items to its owners. An Opportunity Fund Investment may consist of stock or a partnership interest in an Opportunity Fund that invests in a Opportunity Zone business, or it may be an investment in an Opportunity Fund that itself is a trade or business. See Part 2 of this alert series.
8 Guidance about how and when the two elections must be made will need to be developed. Because this is a separate election from the election to defer gain, it should not be affected by the rule that no election to defer gain can be made if an election previously made is in effect.
9 Because the Recognition Date for Deferred Gain in less than 10 years away, only appreciation on the Opportunity Zone Investment itself (as opposed to the Deferred Gain on the previous investment) will be impacted by this election.
10 As previously noted, an Opportunity Fund Investment may consist of stock or a partnership interest in an Opportunity Fund that invests in a qualified Opportunity Zone business, or it may be in an investment in an Opportunity Fund that is itself a trade or business. The mark-to-market rule applies to the sale of the Opportunity Fund Investment, not the sale of an Opportunity Fund's trade or business assets.
11 The taxpayer's basis would have been stepped up by 10 percent of the deferred gain in Year 5 and an additional 5 percent of the deferred gain in Year 7, resulting in tax on 85 percent of the deferred gain.
