In 2017, Congress passed the Tax Cuts and Jobs Act. Within that voluminous piece of legislation was a relatively small provision that received bipartisan support, called the Investing in Opportunity Act. Through the provision, investors are able to defer and reduce their tax burden on capital gains by investing the proceeds in areas called Opportunity Zones (defined below). The goal of the provision is simple: spur economic investment in low-income communities.
The Investing in Opportunity Act created areas known as “Opportunity Zones.” Opportunity Zones are certain low-income census tracts in a state that have been designated by the state’s governor as opportunity zones.
Detroit, being a city on the rise, has many such census tracts that former Gov. Snyder designated as Opportunity Zones, making them ripe for investment.
How is the Money Invested?
The legislation created investment vehicles called Qualified Opportunity Funds (QOFs). An investor generally sells an asset to an unrelated person, whether it is real property, art, stocks, or any other assets that generate capital gains. Within 180 days of the sale, the investor reinvests the capital gains from that sale in a QOF. To qualify as a QOF, 90 percent of the QOF’s assets/investments must be qualified opportunity zone business property, qualified opportunity zone corporate stock, and qualified opportunity zone partnership interests.
Capital Gains in QOFs
The incentives for investors change depending on the duration of their investment in a QOF, but all gains invested in QOFs benefit from deferment until the earlier of the date on which the investor disposes of the QOF investment and Dec. 31, 2026. If the investor keeps money in a QOF for five years, the investor only recognizes 90 percent of the gain deferred in the QOF. If the investor keeps the money invested for seven years, the investor only recognizes 85 percent of the gain deferred. However, to get the 15 percent gain exclusion, the investor would need to put the money into a QOF before the end of 2019 to hit the 2026 deadline for tax deferment.
One of the most striking features of the Investing in Opportunity Act is the break afforded to investors who keep an investment in a QOF for 10 years or longer. If an investor buys into a QOF and holds the investment for 10 or more years, that investor does not recognize any of the gain from the subsequent appreciation in the QOF investment. The investor would have to pay tax in 2026 on the original amount put into the QOF (with the 10- or 15-percent tax break) but would pay zero tax on appreciation in the QOF itself.
To put all of this in perspective: an investor sells a piece of art for a $100,000 gain. Within 180 days of the sale, the investor puts all $100,000 into a QOF. If the investor buys into the QOF before the end of 2019 and the investor holds the QOF investment for at least 10 years, in 2026 the investor would pay tax on 85 percent of the $100,000 (or $85,000). If the investor buys in after 2019, but before 2021, the investor will pay tax on 90 percent of the original investment (or $90,000).
When the investor sells its QOF interest, the investor will pay the reduced tax on the initial investment, and pay zero taxes on the gain realized from the investment in the QOF. For example, if the investor above sells the QOF investment after 10 years for $500,000, the investor would recognize no gain from the $400,000 of appreciation in the QOF investment.
Concerns and Risks
The tax benefits offered by investments in Opportunity Zones will sound tempting to many investors, but the potential rewards do not come without equivalent risks and drawbacks. First, the nature of an Opportunity Zone itself creates risk. Opportunity zones are located in low-income census tracts, which have a poverty level of more than 20 percent, or are adjacent to a census tract with such a poverty level. High poverty areas create inherently risky investments.
Second, a single investor likely does not have enough capital gains to finance an entire opportunity zone project, requiring multiple parties to fund together. Multiple investors in one project can lead to investor relation issues. Third, the IRS has not finished publishing the regulations controlling Opportunity Zone investment. The drafters of the Investing in Opportunity Act left many details for the IRS to flesh out with regulations. While some regulations have been published, more are on the way, which leads to uncertainty in the Opportunity Zone market as a whole.
With money pouring into the city of Detroit, many investors will look to take advantage of the tax breaks afforded by the Opportunity Zones in the city. Opportunity Zone investments appear to be a clever way to generate investment in low-income areas, while giving investors sufficient incentives to put money into these risky areas. It will be interesting to see the effect this program has on investments in the Detroit area.
Max Mittleman is an associate in the Southfield office of Jaffe Raitt Heuer and Weiss and a member of the firm’s Real Estate and Privacy and Data Security Practice Groups, where he concentrates his practice on providing legal services in the areas of commercial, industrial, retail, and residential real estate to private and institutional developers, builders, management companies, real estate brokers, and individuals.