The 2017 Tax Cut and Jobs Act resulted in many benefits for investors. One provision in particular that received bipartisan support created a tax benefit for investing in qualified Opportunity Zones.
Identified by state governments and approved by the federal government as economically distressed areas, Opportunity Zones present financial incentives for investors to help revitalize struggling communities. Additional regulation on Opportunity Zones is anticipated in the coming weeks, so understanding the environment today is important for investors.
The Tax Cut and Jobs Act included four main ways for investors to take advantage of Opportunity Zones:
—It gives investors the ability to roll over capital gains from other, recently sold investments into new investments in Opportunity Zones (the “Invested Gains”).
—It defers taxation on the Invested Gains.
—It excludes up to 15 percent of the Invested Gains from taxation (if the investment is held for at least seven years).
—It excludes all post-investment gains on the Invested Gains from taxation (if the investment is held for at least 10 years).
The reality is, anyone can invest in these funds and potentially receive significant, direct benefits — though those who can make significant capital gains investments have the most to gain. However, any investment comes with risk, and Opportunity Zones are no different. This, coupled with many still unanswered questions (that it is hoped will be resolved soon by forthcoming regulations) means investors should understand a few things first:
What are the Ways to Invest in Opportunity Zones?
There are two ways to invest in an Opportunity Zone: you can either create your own fund or you can invest in a third party’s fund.
What is the Timeline for Using Opportunity Zone Funds?
The Tax Cut and Jobs Act put significant time constraints on when a person could invest in an Opportunity Zone. While this presents a challenge for both investors and fund operators, it also ensures that money is quickly going into projects, which in turn helps struggling communities faster.
If you’re an investor, when you sell your capital asset that generates the Invested Gains, you have only 180 days to invest the Invested Gains into a fund. Once invested, the fund must deploy the Invested Gains quickly to ensure the fund continues to meet an asset test required by law — which means the fund must be able to show, every six months, that at least 90 percent of its assets qualify as “qualified opportunity zone business property.” Like everything, there are exceptions to this rule, but this is what the majority of people adhere to.
What Due Diligence Is Involved When Investing in Opportunity Zone Funds?
Given the short timeframe to invest, it’s easy to skimp on due diligence. Don’t. If you are investing in a third-party fund, you need to make sure you are comfortable with the fund’s business plan, the management team of the fund, and things like the fund’s governance documents and investor rights.
If you are forming your own fund, you will still have all of the standard due diligence related to the assets you plan to acquire — but you also need to make sure that your fund will meet the threshold test. In addition to all the Opportunity Zone-specific due diligence, you will need to do all the normal due diligence you might do for any deal (e.g. is the return on investment realistic? What risks are associated with the intended property or equipment? Etc.).
What Assets Meet Requirements for Opportunity Zone Funds?
There are many requirements that must be met for property or equipment to be “qualified opportunity zone business property.” While you should review those requirements with your legal counsel, there are two key requirements that can cause difficulty for potential investors.
The first is the purchase date. For an investment to meet the Opportunity Zone requirements, an asset needs to have been purchased after December 31, 2017. While the law has left some room for related party transactions, where you might sell the asset to a fund in which you also participate, the rules are fairly strict and generally limit the seller to 20 percent or less of the fund.
The second is the Asset Threshold Test. This is one of the places we anticipate being clarified by coming regulations. As mentioned, 90 percent of the assets of a fund must be qualifying opportunity zone business property or an equity interest in a subsidiary that owns qualifying opportunity zone business property.
The proposed regulations have offered some relief on this requirement, by allowing a subsidiary of a fund to hold only 70 percent of that subsidiary’s assets in qualifying opportunity zone business property. Putting those two requirements together, a carefully managed fund could still qualify even if only 63 percent of its assets constituted qualifying opportunity zone business property. If for some reason a fund falls below the asset threshold, the IRS will impose a steep penalty that is determined by a formula based on how much a fund falls below the threshold.
Opportunity Zones present a great way for potential tax savings while helping businesses produce more jobs and strengthen the economy in financially disadvantaged areas. Coupled with proper due diligence and consultation with legal counsel, Opportunity Zones are worth consideration by those looking for their next investment.
