Senator Tim Scott, one of the sponsors of the bill that created opportunity zone legislation recently issued a warning to investors about being mindful of the law’s purpose to revitalize under-served and low-income census tracts. The moderator of Bisnow’s Opportunity Zone Summit in June of 2019 asked Senator Scott to end his comments on a positive note. In doing so, he quipped “I’m positive that if the opportunity zone program isn’t benefiting the communities it’s meant for, I’ll kill the program.”
Census tracts are small, relatively permanent statistical subdivisions of a country. According to the United States Census Bureau, census tracts average about 4,000 citizens.
While we must keep an eye on making sure opportunity zone (OZ) legislation remains intact, there is good news about the potential for substantial tax benefits for investors anticipating a capital gain in the next several years. Federal Opportunity Zones exist in 18 states, including 260 census tracts in Georgia.
Background on the Investing in Opportunity Act
The legislation was passed as part of the Tax Cut and Jobs Act in late 2017. It provides for a triple tax break, which includes:
- Temporary deferral of tax on capital gains that are invested in qualified opportunity funds (recognized on earlier of disposal date or December 31, 2026)
- A 10% exclusion of the original reinvested gain from taxable income after 5 years, and 15% after 7 years
- Permanent exclusion of tax on future appreciation inside the fund if held for at least 10 years
The Power of the Triple-Play Tax Break
The opportunity zone tax break can result in substantial gains compared to non-opportunity zone investments, especially for those who can maintain their investment over 10 years. Assuming a reasonable annual return and a 23.8% capital gains rate, the difference in after-tax net gain between a non-OZ and OZ investment could be substantial.
Among the zones certified by the treasury Investments can be made in any of 8,700 zones certified by the Treasury, including a large opportunity zone in Gwinnett County and in other areas of greater Atlanta or even the nation.
Since the Tax Cuts and Jobs Act passed, two additional sets of regulations have been issued. The most recent, in April 2019, provides guidance and rules clarification on inclusion events and safe harbor rules many investors had been waiting for.
“The guidance this April is positive in the sense that it provides further clarification for investors while also addressing some of the concerns expressed by some of our clients seeking to take advantage of opportunity zones,” said Chris Conrad, Tax Partner in Smith & Howard’s real estate group.
The original legislation was written such that individuals already owning property in an opportunity zone would have a much harder time realizing all the benefits when starting a fund using their own property. Now, it is clear that opportunity zone landowners may lease their property and maintain any level of ownership of the fund they desire. Pre-existing leases do not qualify and leases must take effect after 12/31/17; there are also specific rules in the regulations for how to properly value a lease, so special attention must be given to lease contracts.
Fortunately, the guidance issued in April 2019 relieves most of that concern in support of the legislation’s goal to promote activity in these zones.
Having your money tied up for 10 years is a long time, but it’s necessary if your goal is to qualify for the maximum benefit of an opportunity fund investment.
The new guidance allows investors an option for easing cash flow. Once the property has stabilized, a qualified opportunity zone fund could take out a loan on the property and allocate the funds for partner or shareholder distributions.
The risk of debt-financed distributions is that if the venture goes bankrupt, the partnership is on the hook for the loan, in addition to the loss of capital. Also, investors must be careful not to distribute cash in excess of their tax basis or risk triggering gain and eliminating the qualified OZ benefits.
Other Clarifications to Note from the New Guidance:
- Investors can reinvest proceeds of a sale within the fund if they reinvest in another opportunity zone within 12 months. In that case, changing investments from one qualified property to another doesn’t stop the clock on the 10 years required to reach permanent exclusion of the capital gain tax on the original investment.
- The opportunity zone must generate 50% of gross receipts from an active trade or business within the zone. Also, triple net leases do not qualify as they were specifically excluded in the new regulations. The legislation allows several forms of proof in meeting the 50% threshold. Smith & Howard can help you determine the most advantageous method for your situation.
The official 169-page guidance document issued April 17 includes plenty of additional nuance and rules, including:
- Discussion of how gain-triggering events are defined and when a gain must be recognized
- Clarification of original use for vacant property
- Time-frame for electing deferral on a net 1231 gain
- Status of property that straddles an opportunity zone
As with any tax legislation, those considering taking advantage of the O-Zone opportunities should consult with their tax advisor to ensure they are approaching the investment in a tax-wise manner and in line with the law. Smith & Howard is well versed in the guidance and would be happy to answer your questions. Please contact Chris Conrad or a member of our tax team or fill out the contact form below if you’d like to discuss your situation and how an opportunity zone investment could serve you – and your community.