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Opportunity Zone Tax Credit Incentives

As part of the Tax Cuts and Jobs Act of 2017, Congress established a new investment vehicle known as Qualified Opportunity Funds (O-Funds). This program has the potential to tap into trillions of dollars in unrealized capital gains that can be used to invest into qualifying businesses and real estate.

The program directs investment into qualifying geographic areas called Qualified Opportunity Zones (QOZ) through the O-Funds. Taxpayers that invest capital gains into O-Funds will receive a number of tax benefits for investing in these funds. In turn, the O-Funds will invest into eligible business property located in QOZs.

How does the Opportunity Zone Tax Credit program work?

The program directly targets unrealized capital gains by providing three key tax benefits. Within 180- days of realizing a capital gain, an investor may now roll over the capital gain amount directly into an O-Fund and become eligible for the program's benefits:

  • Deferral – A taxpayer can invest capital gains into an O-Fund and defer payment of capital gains tax until the investment is sold OR until December 31, 2026, whichever comes first.
  • Step-Up in Basis– In addition to the deferral, the taxpayer receives a step-up in basis for holding the investment.
    • After 5 years, the taxpayer will receive a step-up of 10%
    • After 7 years, the tax payer will receive an additional step-up in basis of 5%
    • This allows for a total step up in basis of up to 15% on the original capital gain. The remaining 85% is recognized when the investment is sold or December 31, 2026, whichever comes first.
  • Tax Exemption– When an investment in the O-Fund appreciates, the taxpayer is exempt from paying capital gains tax on the appreciation if the investment is held for at least 10 years. This exemption only applies to the appreciation and not the original gain.

In order to receive these benefits, the taxpayer must invest in an O-Fund, which is required to invest in QOZs.

Qualified Opportunity Zones

QOZs are the driving force behind this program. In early 2018, state and territorial governments submitted qualifying census tracts to the U.S. Department of the Treasury for certification as an opportunity zone. Census tracts needed to meet certain thresholds to be eligible for certification, and each state or territory could only submit 25% of all qualifying tracts.

Eligible areas were determined at the census tract level, and the requirements for eligible census tracts are pulled from the New Market Tax Credit (NMTC) program. Tracts were eligible to be designated as a QOZ if they met one of the following requirements:

  • Poverty rate > 20%
  • Median Family Income (FMI) threshold of:
    • FMI < 80% of the state's FMI for rural areas
    • FMI < 80% of the MSA's FMI for urban areas
    • FMI < 85% of the state's FMI for high migration rural counties
  • Census tracts contiguous to an eligible tract with an FMI < 125% of the FMI of the adjacent eligible tract (only 5% of a state or territory's QOZs can be contiguous tracts) 

On June 14, 2018, the treasury completed the certification process for alI 50 states and U .S. territories. The statute only calls for a one-time designation, so for now, these tracts are final.

Introduction to Opportunity Zones_Page_2

National Opportunity Zone Map

Qualified Opportunity Funds

O-Funds are "investment vehicle[s] organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property". Taxpayers will also be able to self-certify as an O­Fund by completing a form and attaching it to their federal income tax return. The form is expected to be released Summer 2018.

Treasury is currently working on additional guidance for O-Funds, which should be released some time in Summer 2018. In April 2018, IRS released "FAQs" on the program regarding QOZs and O­Funds which can be found here. The fund must meet the criteria outlined in the statute and forthcoming guidance.

O-Funds must hold 90% of assets in QOZ Property. The percentage is determined by the average on two test dates:

  • End of the 1st 6-month period of the taxable year
  • Final day of the taxable year 

Qualified Opportunity Zone Property is defined as: 

  • Stock or partnership interest in a business that is or being organized as a QOZ Business 
  • QOZ Business must meet the following criteria
    • Substantially all of the tangible property owned or leased by the taxpayer is QOZ Business Property
    • At least 50% of income is derived from the active conduct of such business
    • A substantial portion of the intangible property of the business is used for the active conduct of such business
    • Less than 5% of unadjusted basis of property is attributable to nonqualified financial property
    • Cannot engage in "sin" businesses (ex: gambling facilities, liquor stores, private/commercial golf course, country club, massage parlor, etc.)

QOZ Business Property

  • If the original use of the property in the QOZ commences with the O-Fund, tangible property used in a trade or business OR
  • O-Fund substantially improves the property, and substantially all of the use of such property is in an Opportunity Fund during substantially all of the holding period for such property.
    • Substantial improvement defined as follows: During any 30-month period beginning after the date of acquisition of the property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis at the beginning of the 30-month period.
  • Must be located within a QOZ

Penalties apply for non-compliance. The penalty is calculated using the federal short-term rate plus 3%. It is assessed for the months of non-compliance and is based only on the shortfall.

Important Notes

  • Only the amount of the capital gain needs to be invested in the O-Fund. Non-capital gain investments do not receive the tax benefits outlined above.
  • The investor and O-Fund do not need to be located in a QOZ to take advantage of the program
  • An O-Fund can invest in multiple QOZs
  • Final day to invest in O-Fund in order to receive 15% step-up in basis is December 31, 2019
  • Final day to invest in O-Fund in order to receive 10% step-up in basis is December 31, 2021
  • Treasury will publish self-certification procedure for O-Funds in Summer of 2018

Example Investment Scenario

Assume that a taxpayer sells an asset on November 1, 2018 with a $500,000 capital gain. The investor then decides to invest the gain into an O-Fund on January 1, 2019 (within the 180-day period). The diagram below maps out the different benefit scenarios based on different holding periods of the investment.

Date Invested in O-Fund: January 1, 2019
Holds O-Fund Investment for 3-Years and Sells for $525,000Holds O-Fund Investment for 6-Years and Sells for $560,000Holds O-Fund Investment for 8-Years and Sells for $700,000Holds O-Fund Investment for 10-Years+ and Sells for $800,000
3-Year deferral of capital gains tax on original gain 6-Year deferral of capital gains tax on original gain7-Year deferral of capital gains tax on original gain (max: Dec. 21, 2026)7-Year deferral of capital gains tax on original gain (max: Dec. 21, 2026)
 10% / $50,000 step-up in basis10% / $50,000 step-up in basis10% / $50,000 step-up in basis
  Additional 5% / $25,000 step-up in basisAdditional 5% / $25,000 step-up in basis
   Exempt from capital gains on $300,000 O-Fund investment appreciation

Opportunity Zones v. Other Programs

The Opportunity Zone program has been compared to other programs such as New Market Tax Credit and 1031 Exchanges, but there are key differences between the programs.

New Market Tax Credits (NMTC)

  • Notably, the Opportunity Zone program is a capital investment program where NMTC focuses on structuring debt
  • QOZ tracts are one-time designations
  • There is no limit to the amount of capital that can be invested through the Opportunity Zone program (investors will determine the success of the program)

1031 Exchanges

  • Capital gains from any asset class can be rolled into an O-Fund
  • QOZ deferrals sunset on December 31, 2026
  • QOZ gains can also receive a 15% step-up in basis rather than a 100% deferral
  • Additional appreciation of the investment is exempt from capital gains tax
  • Only the gain needs to be invested into the O-Fund

Final Thoughts

The Opportunity Zone program represents a major investment opportunity and could tap into trillions of dollars of unrealized capital gains and provides powerful incentives to drive investments into Opportunity Funds. Taxpayers who take advantage of the program may receive tax defermentsnational, step­ups in basis, and tax exemptions on appreciation. There are no caps on the volume of capital flowing into 0-Funds, and these funds are required to invest into Opportunity Zones. Investments can be structured to direct capital into real estate development, venture capital, business incubators, infrastructure projects, and other economic or community development efforts.