Prior to 2020, opportunity zone investments allowed investors to obtain tax benefits by investing in economically distressed communities that had been designated as opportunity zones. The COVID-19 pandemic made it much harder for investors, as a practical matter, to obtain those benefits.
But the IRS came to the rescue, relaxing certain requirements that applied to investors and qualified opportunity funds (QOFs) alike. More recently, 2020’s other top news story, the election of Joe Biden as president, has scrambled the chessboard for investors who have already invested gains in QOFs.
Under the opportunity zone rules, an investor can defer a capital gain generated from other sources by investing that gain in a QOF within 180 days of the date the gain otherwise would have been recognized. The gain is deferred until Dec. 31, 2026 (or, if sooner, the date on which the investor disposes of his QOF interest).
This gain is taxed at the rate in effect for the year of recognition. In addition, an investor can permanently exclude 10 percent of the gain on a QOF interest held for at least five years, or 15 percent of the gain on a QOF interest held for at least seven years (but only for investments made by Dec. 31, 2019, i.e., seven years before Dec. 31, 2026). The most tantalizing benefit is that an investor who holds a QOF interest for at least 10 years can exclude all additional gain from the QOF interest.
As an example, consider an investor who recognizes a capital gain of $100 today. On Dec. 18, 2020, he invests that $100 in a QOF. The investor then sells his QOF interest 10 years later for $350. In this scenario, the investor recognizes no gain (and therefore incurs no tax) in 2020. In 2026, he recognizes $90 of gain ($100 of deferred gain, minus 10 percent of the gain excluded as a result of holding his fund interest for five years). When he sells his QOF interest 10 years later, he does not recognize any of the $250 of additional gain from his subsequent sale.
There are several requirements that a fund must comply with in order to qualify as a QOF, including a requirement that 90 percent of its assets be qualified opportunity zone business property (QOZBP) and/or interests in certain entities that are qualified opportunity zone businesses (QOZBs).
An entity is considered a QOZB if at least 70 percent of its tangible assets are QOZBP. These 90 percent and 70 percent levels are generally tested on June 30 and Dec. 31 of each year. Cash held by a QOF is not a “good” asset for purposes of the 90 percent test. Cash held by a QOZB can be a “good” asset for purposes of the 70 percent test, if the QOZB documents how it expects to — and actually does — spend the cash within 31 months to further the QOZB’s business (the working capital safe harbor).
IRS takes on COVID-19
As one can imagine, the economic upheaval caused by the COVID-19 pandemic has made it much more difficult for investors to invest gain into QOFs before the 180-day deadline. It’s also made it tougher for QOFs and QOZBs to deploy contributed capital in compliance with the opportunity zone rules. In response, the IRS issued the following relief measures:
- Any investor’s 180-day deadline that would otherwise fall between April 1 and Dec. 31, 2020, is automatically extended to Dec. 31, 2020;
- Any failure of a QOF to meet the 90 percent test on a testing date that falls between April 1 and Dec. 31, 2020 is ignored; and
- QOZBs receive an additional 24 months to expend cash reserved under the working capital safe harbor.
For investors, this means that they may have until Dec. 31, 2020 to invest gains otherwise recognized as early as Oct. 4, 2019.
The presidential election (2020’s other big news story) has increased the likelihood that federal income tax rates will be going up — subject to the ultimate determination of control of the Senate.
Under President Biden’s tax plan, taxpayers with more than $1 million of income would no longer receive a preferential federal rate of 20 percent on long-term capital gains and would instead be subject to the ordinary income tax rate, which would also be increased to 39.6 percent. For investors who invest gains in QOFs after any such changes take effect, the opportunity zone exclusions and deferrals would be even more attractive.
However, investors who have already invested gains in QOFs would find themselves in a quandary. If an existing QOF investor expects to have more than $1 million of income in 2026 (when the deferred gain will be recognized, if not previously triggered), the gain will be subject to a much higher tax rate than it would have been if the QOF investment had not been made.
Even if an investor obtains the full 15 percent exclusion of his deferred gain, he will still be subject to an effective federal tax rate of 33.66 percent ((1-15 percent) x 39.6 percent). An investor will need to determine whether the benefit of excluding all additional gain from his QOF interest — combined with the likelihood of holding his QOF interest for 10 years — outweighs this likely additional tax cost. If it does not, then an investor may decide to trigger the gain prior to a rate hike, thereby locking in the lower tax rate on the original gain but giving up the exclusion of future gain from taxation.
See the wizard
Going forward, these new complexities and calculations make it all the more important that opportunity zone investors seek the advice of professionals having demonstrated expertise with these specialized investments.
Marko Belej leads the tax practice group at the law firm of Jaffe Raitt Heuer and Weiss in Southfield. He specializes in corporate and real estate matters, and has transactional expertise in support of all tax matters from business owners acquiring a new company to the establishment of a new business anywhere in the United States.