Opportunity Zone Program Offers A New, Tax-Efficient Vehicle For Investors And Developers
On December 22, 2017, President Donald Trump signed into law the Tax Cuts and Jobs Act (the “Act”), which contained a potentially lucrative tax incentive program (the “Opportunity Zone Program”) to encourage long-term investments in low-income communities designated as “opportunity zones” by the Secretary of the Treasury.1 The Opportunity Zone Program offers developers, including start-up companies developing new technologies in the energy, chemical, and infrastructure industries, an exciting, new opportunity to attract private placement funds into business operations and projects constructed in such opportunity zones. Under the Act, the Opportunity Zone Program allows investors to:
On October 19, 2018, the Department of Treasury and the Internal Revenue Service issued initial proposed regulations and guidance for the Opportunity Zone Program. The proposed regulations clarify, among other things, the types of gains that are eligible for deferral, the requirements for QOFs, and the application of these rules to partnerships.
Tax Treatment of Deferral
Capital gains that are deferred and invested pursuant to the Opportunity Zone Program are included in income on the earlier of (i) the date on which the investment in the QOF is sold or exchanged, or (ii) December 31, 2026. The amount included in gross income as of such date is equal to the excess of (i) the lesser of (A) the amount of eligible gain excluded and invested in the QOF; or (B) the fair market value of the interest in the QOF attributable to the deferral of eligible gains, over the taxpayer’s adjusted basis in the qualifying QOF investment (adjusted as discussed below). An investor’s initial basis in an investment in a QOF is zero. Unless investors dispose of their interests in a QOF prior to December 31, 2026, all deferred gains will be required to be recognized in the taxable year that includes December 31, 2026 (subject to the basis adjustment rules discussed below).
Taxpayer A has $100 of eligible capital gains and elects to defer it pursuant to the Opportunity Zone Program on January 1, 2023. The $100 is properly invested in a QOF with a basis of zero. On December 31, 2026, Taxpayer A has not changed his position with respect to the investment, which is now worth $120. Taxpayer A must include $100 ($100 gain excluded – $0 basis) in income on December 31, 2026.
If on December 31, 2026, Taxpayer A has not changed his position with respect to the investment, but the investment is now worth $80, Taxpayer A would include $80 ($80 fair market value - $0 basis) in income.
Basis Adjustment for Investments
For purposes of determining the amount of gain recognized upon a disposition of the investor’s interest in the QOF prior to December 31, 2026 (or automatically at December 31, 2026), the Opportunity Zone Program provides for an increase in basis in the investment if it is held for five or seven years. If the investment is held for at least 5 years, the basis of the investor’s interest in the QOF is increased by an amount equal to 10% of the gain deferred. If the investment is held for at least 7 years, the basis of the investor’s interest in the QOF is increased an additional 5% of the gain deferred.
If an investor in a QOF holds the interest for at least 10 years, the taxpayer may elect to increase the basis of his investment to its fair market value on the date such investment is sold or exchanged. This allows for the investor to permanently exclude from gross income all post-investment gains upon a disposition of the interest in the QOF. The following are several examples illustrating the application of these rules:
Example 1: Eligible Gains Reinvested in a QOF in 2019
Taxpayer A has $100 of eligible capital gains and elects to defer it pursuant to the Opportunity Zone Program in 2019. The $100 is properly invested in a QOF with a basis of zero. On December 31, 2026, Taxpayer A has not changed his position and has held the investment for at least 7 years. Accordingly, Taxpayer A is permitted to adjust his basis in the QOF by 15% of the amount of the deferred gain or $15. The investment is now worth $120. Taxpayer A must include $85 ($100 deferred gain - $15 basis) in income on December 31, 2026. Taxpayer A's basis in the investment is increased as of December 31, 2026 by $85 to $100.
Example 2: Eligible Gains Reinvested in a QOF in 2021
Same facts as Example 1, except Taxpayer A elects to defer the eligible gain pursuant to the Opportunity Zone Program in 2021. As of December 31, 2026, Taxpayer A is permitted to adjust his basis in the QOF by 10% of the amount of the deferred gain or $10. Taxpayer A must include $90 ($100 deferred gain - $10 basis) in income on December 31, 2026. Taxpayer A's basis in the investment increased by $90 to $100.
In each of the examples 1 & 2 above, if Taxpayer A holds the investment for at least 10 years before Taxpayer A sells the investment at its fair market value of $200 and elects a step-up in basis in accordance with 26 USC 1400Z-2(c), then Taxpayer A's basis in the investment is stepped up to the amount realized ($200), and no gain is included in Taxpayer A's income from this transaction.
Implications for Investors and Developers
The Opportunity Zone Program offers many potential benefits for taxpayers; however, each taxpayer should analyze their own situation to determine how to best utilize the program. For example, due to the time period limitation on the deferral in the Opportunity Zone Program, an exchange under section 1031 of the Code may be preferable for investors in real estate as it allows the taxpayer to potentially defer gains until the death of the taxpayer (when heirs may elect for a stepped up basis in the assets). Additionally, in eligible energy projects, partially utilizing tax-equity in lieu of deferring capital gains under the Opportunity Zone Program may prove to be an attractive tradeoff for investors. In such case, the benefits from the tax free treatment of post-investment gains would likely outweigh those from the step-ups in basis available after the 5 and 7 year holding periods.
For further in-depth analysis regarding the Opportunity Zone Program and the proposed regulations and guidance, please see Opportunity Zones White Paper. A second set of proposed regulations is expected to be released near the end of 2018.
Mark J. Riedy
Heather L. Preston
Menlo Park, CA
John C. Livingston
Dongyu Eddie Wang