Alert: Update on Qualified Opportunity Zone Investing
In a packed hearing before the IRS on February 14, 2019 about Opportunity Zones, stakeholders argued for changes to the proposed Treasury regulations governing investments in these specially-designated geographic areas. In addition to specific calls for clarification, a number of the parties testifying at the hearing sought guidance on how the Opportunity Zone regulations will interact with other federal programs, such as the low income housing tax credit.
Also in February, multiple news stories reported on the tax benefits flowing to wealthy companies like Amazon and GE from Opportunity Zone developments in New York City and Boston, respectively, and questioned the purported social benefits of the new law.
All of this suggests that changes may be coming. Here is what we know for now.
WHAT IS AN OPPORTUNITY ZONE?
The tax legislation passed by Congress and signed into law by President Trump in December 2017 contained a provision that was little-discussed at the time, allowing states to designate “Opportunity Zones.” An Opportunity Zone is a low-income census tract identified by a state’s governor, and certified by the Secretary of the Treasury. In Massachusetts, for example, Governor Baker and the U.S. Treasury have certified 138 Opportunity Zones. In October 2018, nearly a year after the original tax legislation was enacted, the IRS issued proposed regulations intended to clarify some of the Opportunity Zone rules. These proposed regulations were the subject of the February 14, 2019 hearing.
The chief benefit of an Opportunity Zone designation is that certain types of investments made in that zone now benefit from several layers of positive Federal income tax treatment. The idea behind the legislation is to encourage investment in economically-depressed communities, either through managed funds – called “Qualified Opportunity Funds” – that pool investors’ money in order to invest in real estate or an operating business located in the zone, or through direct investment in zone real estate or a zone operating business.
POTENTIAL BENEFITS OF INVESTING IN A QUALIFIED OPPORTUNITY FUND
From an investor’s perspective, the law provides several potential tax advantages.
First, the law provides income tax deferral. It allows an investor to sell most any type of capital gain property (for example, stocks, real estate, or any other type of capital assets) and, as long as the capital gains are re-invested in a Qualified Opportunity Fund within 180 days of the sale, the investor can delay including those original gains in his or her taxable income until the earlier of (1) the date the investor ultimately sells the Qualified Opportunity Fund investment, or (2) December 31, 2026.
Second, the law provides the potential for income tax reduction. If an investor holds the Qualified Opportunity Fund investment for at least 5 years, then the law permanently excludes 10% of the investor’s original capital gain from his or her future taxable income. If the investor holds the fund investment for at least 7 years, then the law permanently excludes an additional 5% of the investor’s original gain from his or her future taxable income – for a total gain reduction of 15%.
Note that, in light of the December 31, 2026 deferral end-date – which means that an investor’s original capital gain must in all events be included in taxable income by December 31, 2026 – the only way to hold a Qualified Opportunity Fund investment for at least 7 years and get the full 15% reduction in the investor’s original gain would be to make the fund investment by the end of 2019.
Third, the law provides the potential for excluding from tax all future gain on the Qualified Opportunity Fund investment itself, provided that the fund investment is held for at least 10 years. That is, if an investor holds his or her fund investment for 10 years or more, then when he or she later sells, the investor would pay no additional capital gains taxes over and above the taxes already triggered on December 31, 2026 with respect to his or her original gain.
SOUNDS GREAT, BUT WHAT'S THE CATCH?
The tax benefits described above can be significant, in particular if an investor is willing to hold a Qualified Opportunity Fund investment for at least 10 years. The potential downsides are common to any private equity investment or real estate transaction – illiquidity and the risk of poor manager selection.
Regarding illiquidity, by design the law requires long-term investment in an Opportunity Zone in order to receive the maximum income tax benefits. This means that an investor must be willing to lock up his or her investment for at least 5 years, and more likely 10-plus years. In the meantime, taxes will be due on the investor’s original capital gain – included in income on December 31, 2026 at the latest, with the taxes payable in 2027 – without any guaranteed liquidity from the Qualified Opportunity Fund to help pay the tax liability.
Regarding manager selection, the quality of the underlying investment and the management team will matter. Successfully investing in an economically depressed, low-income Opportunity Zone will require skill and experience that traditional fund managers may not possess. There is also ongoing uncertainty about whether a Qualified Opportunity Fund can hold a diverse group of real estate projects and operating businesses, or must be organized as a single-project investment. If the latter, diversification within the fund will not be possible, increasing the risks of fund underperformance. This question – whether managers can effectively and practically structure diversified funds – was a particular focus of the February 14th hearing, and the IRS answer will be important to investors.
The IRS has promised to issue additional guidance about Qualified Opportunity Funds soon. At the 5-hour February 14th hearing, stakeholders raised numerous concerns about the current rules, which may be changed in the final regulations as a result. In the meantime, the proposed federal regulations state that taxpayers are generally entitled to rely on them. On that basis, fund managers have begun forming Qualified Opportunity Funds and seeking capital from investors.
As with any illiquid private investment, we recommend that investors carefully evaluate any Qualified Opportunity Fund, since the income tax benefits – as good as they are – may not be enough to offset a poorly performing fund.