No Cap Limiting Tax Benefit in Opportunity Zones
Unlike other economic development programs, the incentive is not limited to real estate investments, rather businesses that intend to deploy capital and operate in Opportunity Zones can benefit from this incentive.
SAN FRANCISCO—Opportunity Zones, the economic development tool created to stimulate investment in low-income communities, is causing a stir in both start-up and development communities. This tool extends tax advantages to investors in qualified opportunity funds that primarily invest in projects or businesses located in Opportunity Zones.
Unlike other economic development programs, the incentive is not limited to real estate investments. Rather, businesses that intend to deploy capital and operate in Opportunity Zones can benefit from this incentive, says Julie Treppa, tax partner in Farella Braun + Martel’s San Francisco office. As a result, the program has been attracting the attention of investors, developers and business owners, driving up pricing on real estate sales and lease rates within these communities.
Under this program, taxpayers defer recognizing capital gains if within 180 days of when such gains would otherwise be recognized, they make an equity investment in a qualified opportunity fund. But, the initial deferral does not last forever, says Treppa.
Once the fund interest is sold or on December 31, 2026, whichever is earlier, the investor pays tax on the lesser of the deferred capital gain or the fair market value of the qualified opportunity fund investment less its tax basis. The basis initially equals zero, but after five years, it increases by 10% of the capital gain deferred, and after seven years, it increases another 5%. After 10 years, the tax basis in the qualified opportunity fund investment equals its fair market value on the date it is sold.
“In addition to providing for tax deferral, this program potentially allows taxpayers to permanently exclude up to 15% of capital gains invested in a qualified opportunity fund and any post-acquisition appreciation of the fund investment,” Treppa tells GlobeSt.com.
Governors of each state were permitted to designate up to 25% of low-income census tracts within each state boundary as Opportunity Zones. The designations now in existence will expire on December 31, 2028. Nonetheless, taxpayers investing in a qualified opportunity fund on or before that deadline will realize the benefit of the 10-year basis step-up until December 31, 2047.
“A newly formed or pre-existing US entity treated as a corporation or partnership for tax purposes, including LLCs, may elect to be a qualified opportunity fund, provided it states its intent to invest in Opportunity Zones in its organizing documents,” Treppa tells GlobeSt.com. “The fund must invest 90% of its assets in certain businesses or business property located or used in an Opportunity Zone.”
The 90% test is measured by averaging the percentage of qualified property held by the fund six months after it is formed or elects to be a qualified opportunity fund and the last day of its taxable year, she says. The properties include qualified opportunity fund business properties which are tangible properties with an original use that commences in an Opportunity Zone or that is substantially improved within 30 months of the date it is acquired.
Qualified opportunity zone businesses are generally active trades or businesses with certain ties to an Opportunity Zone, such as owning or leasing at least 70% of its assets in the zone and having at least 50% of its gross income derived from conduct in the zone, Treppa says.
“Businesses engaged in certain ‘sin’ businesses including a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling or a liquor store do not qualify,” she points out.
The program is broad-based as it is available to virtually any taxpayer with capital gains. Businesses and high net-worth individuals looking to remove unrealized capital gains from balance sheets in a tax-efficient manner can take advantage of the program, as can social impact investors looking to benefit underserved communities. Moreover, there is no cap at the state or federal level limiting the extent to which the tax benefit is available. Therefore, this incentive is expected to drive a new source of capital to Opportunity Zone projects and businesses in the immediate future, Treppa concludes.