The 2017 Tax Cuts and Jobs Act, enacted Dec. 22, 2017 (the “Act”), offers new tax incentives aimed at benefiting low-income communities (“LICs”) (as defined under the new markets tax credit (“NMTC”) regulations) through the creation of Qualified Opportunity Zones (“Opportunity Zones”). Congress believes the Opportunity Zone legislation will encourage investments that will be used to start businesses, develop abandoned properties and provide low-income housing in low-income, economically distressed communities. The Act allows for creation of Qualified Opportunity Funds (“Opportunity Funds”) to serve as the investment vehicles to drive the new incentive.
Generally, taxpayers with capital gains from the sale or exchange of property may, within 180 days of the disposition, invest such gain in an Opportunity Fund and defer recognition of the gain for federal income tax purposes. The Opportunity Funds will use the investment proceeds to acquire partnership interests or stock in a qualified opportunity zone business (“Qualified Business”) or to purchase and/or substantially improve certain property in an Opportunity Zone.
Opportunity Zones Explained
Opportunity Zones are LICs that are nominated by the chief executive officers of states or U.S. possessions, and certified by the Treasury Secretary. The Conference Report for the Act states that the CEOs should give particular consideration to LIC census tracts that “(1) are currently the focus of mutually reinforcing state, local, or private economic development initiatives to attract investment and foster startup activity; (2) have demonstrated success in geographically targeted development programs such as promise zones, the new markets tax credit, empowerment zones, and renewal communities; and (3) have recently experienced significant layoffs due to business closures or relocations.” Under the Act’s time-line, Gov. Phil Bryant will have until March 21, 2018 to make his Opportunity Zone nominations in writing (although he can request and receive a 30-day extension). Generally, the Treasury Secretary will certify and designate the approved tracts as Opportunity Zones within 30 days after receiving a governor’s nominations.
Up to 25 percent of the eligible LIC tracts in a state may be designated as Opportunity Zones. In addition to the LIC census tracts, a non-LIC census tract contiguous with an Opportunity Zone may also be designated as an Opportunity Zone if it has a median family income of not more than 125 percent of the median family income of the zone that is contiguous; however, not more than five percent of the 25 percent may be designated this way. Based on the 2011-2015 American Community Survey data provided by the Census Bureau (the applicable reference), Mississippi currently has 401 eligible LIC census tracts. Thus, approximately 101 LIC census tracts may be nominated by Governor Bryant to be designated as Opportunity Zones. On Feb. 8, 2018, the IRS issued Revenue Procedure 2018-16 to provide detailed guidance to the CEOs regarding the procedure for designating Opportunity Zones, including calculation of the number of eligible primary and contiguous tracts, etc.
Opportunity Fund Organization
To qualify as an Opportunity Fund under the Act, the entity that receives the capital gain investment must be organized as either a corporation or a partnership and be certified by the Department of Treasury. The Opportunity Fund will then use the investment proceeds to (a) acquire stock or a partnership interest in a domestic corporation or partnership that is a Qualified Business, or (b) acquire or substantially improve certain tangible business property used in an Opportunity Zone. Thus, the investor’s upside return potential on his reinvested capital gain will be driven by the success of the underlying project (i.e., the Qualified Business) into which the Opportunity Fund invests. Contrast this with the investor’s return in the NMTC program, where the investor gets a defined federal and/or state income tax credit in exchange for investing in a NMTC project.
What is a Qualified Business?
A Qualified Business is defined in the Act as a trade of business in which substantially all of the tangible property owned and leased by the taxpayer is qualified opportunity zone business property (“Qualified Property”). Qualified Property, in turn, means tangible property: (a) used in a trade or business of the Qualified Business, (b) acquired by the Qualified Business by purchase after December 31, 2017, (c) the original use of which starts with the Qualified Business or the Qualified Business substantially improves such property, and (d) substantially all the use of which occurs in an Opportunity Zone while held by the Qualified Business. However, as with NMTC projects, the Act specifically prohibits the following “sin” businesses: any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Also, at least 50 percent of the total Qualified Business’ gross income must be derived from the active conduct of such business and the average of the aggregate unadjusted bases of the Qualified Property attributable to “non-qualified financial property” must be less than five percent (these tests are similar to those found in the NMTC provisions for active LIC businesses).
Mechanics of the Incentive
As an up-front benefit, in exchange for rolling over his capital gain into an Opportunity Fund, a taxpayer will defer income recognition of the gain for federal tax purposes. Initially, the taxpayer will have zero basis in his Opportunity Fund investment. Thereafter, if the taxpayer sells his Opportunity Fund investment within five years, he will recognize all of the deferred capital gain at that time. If he holds the investment for at least five years, then the basis in the investment will be increased to 10 percent of the amount of gain deferred, resulting in the taxpayer recognizing 90% of the initial capital gain that was reinvested. If the taxpayer holds the investment for at least 7 years, the basis is increased by an additional 5 percent of the deferred gain, resulting in the taxpayer recognizing 85% of the initial capital gain. If the investment is held for at least 10 years and then sold or exchanged, the taxpayer can elect to have the basis be equal to the fair market value (“FMV”) of the investment on the date of disposition.
An important quirk in the Act as currently written, however, is a provision for mandatory recognition of the deferred gain on December 31, 2026. Thus, even if an Opportunity Fund investment is held for more than ten years, a taxpayer will not be able to completely escape tax on more than 15 percent of the initial capital gain invested. For example, assume a taxpayer makes an Opportunity Fund investment on April 1, 2018 and sells his interest on April 2, 2029 (an 11 year holding period). On Dec. 31, 2026, the statutory gain recognition trigger date, the taxpayer will have held the investment for at least seven years and thus be entitled to a basis allocation of 15 percent. The taxpayer would have to recognize 85 percent of the original deferred gain on Dec. 31, 2026, even though his interest has not been sold. This type of gain is often referred to as “phantom gain” because even though it must be recognized and tax paid accordingly, the taxpayer has not realized any actual liquidity. There is some speculation based on the early analysis of the Act that Congress may (and should) reconsider this 2026 mandatory gain recognition provision.
Continuing with the above example, if the taxpayer sells the Opportunity Fund investment for FMV and makes the FMV basis election (which he would be entitled to do, having met the 10 year holding period requirement), he will not recognize any additional gain. Remember that the taxpayer will have already recognized the 85% phantom gain on Dec. 31, 2026, and so this means that he gets to fully exclude from income any appreciation on his Opportunity Fund investment that might have occurred over the 11 year period.
In summary, the Opportunity Zone provisions give incentive to potential investors in Opportunity Funds by allowing for (a) temporary deferral of capital gain recognition, (b) a possible step-up in the basis of their investment, and (c) possible permanent exclusion of capital gains from the growth of the Opportunity Fund investment if the holding period is at least 10 years.
The new Opportunity Zone program has the potential to unlock huge amounts of investment capital which can be directed into LICs that desperately need the infusion for business and community development and redevelopment. Since the performance of the underlying Qualified Business activity under the Opportunity Fund rubric will drive a potential investor’s return on his investment in the fund (which introduces a different risk profile and analysis than the NMTC program, for example), it remains to be seen if this program, with its current parameters, will take hold and push significant investment into LICs.
» Butler Snow attorneys Alveno N. Castilla and Ashley N. Wicks’ Law Elevated is a column on the latest trends, issues and perspectives facing the legal industry, written by associates of Butler | Snow. For more information, visit www.butlersnow.com or follow Butler | Snow on Twitter @Butler_Snow
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