An Introduction to Opportunity Zones
- Opportunity zones are a new tax benefit created by the Tax Cuts and Jobs Act of 2017 to spur investment in economically distressed communities.
- The tax benefits are two-fold: taxes owed on capital gains can be deferred, and in some cases reduced, if the gains are reinvested in an opportunity zone fund; and the gains on opportunity zone investments held at least 10 years are tax free.
- Statutory reporting requirements were struck from TCJA, but there are efforts underway to fill the information void.
- So far, most opportunity zone investments have been in real estate, but recent Treasury regulations should give investors enough clarity to accelerate investment in other businesses.
Included in section 13823 of the Tax Cuts and Jobs Act of 2017 are two provisions designed to spur investment in targeted low-income areas called opportunity zones. New sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code describe how, in exchange for qualified investments in opportunity zones, a taxpayer can: (1) defer and reduce taxes owed on capital gains; and (2) pay zero tax on post-investment capital gains earned on opportunity zone assets held at least 10 years.
The Rationale for Opportunity Zones
Although the post-recession U.S. economy has entered its 10th year of expansion, job and wage growth has been geographically uneven. Approximately 50 million Americans live in communities where the decline of industries like mining, manufacturing, and textiles has led to stubbornly high rates of unemployment and poverty.
One significant handicap for these communities has been the lack of access to loans, grants, and venture capital needed to start or expand a small business. Opportunity zones were devised to address this gap.
What Is an Opportunity Zone?
An opportunity zone is a designation given to a low-income community in a state or territory. Designation is generally made by a state’s governor and approved by the U.S. treasury secretary. The designation does not confer any federal payments – it isn’t tied to any formula grant, loan program, or entitlement – but people who invest in opportunity zones may qualify for tax benefits.
To be a “low income community,” a population census tract must meet the definition contained in section 45D(e) of the U.S. tax code. In general, the poverty rate is at least 20 percent, or the median family income does not exceed 80 percent of statewide median family income. Some communities that are contiguous to low-income areas also may be designated opportunity zones.
A governor may designate up to 25 percent of a state’s low income communities. The designation expires after 10 years. There are more than 8,700 census tracts designated as opportunity zones across all 50 states, the District of Columbia, and several U.S. territories.
What Are the Tax Benefits?
Opportunity zones provide two tax benefits for investors. First, capital gains from the sale of a traditional asset that are reinvested in an opportunity zone can be deferred and reduced, depending on how long the opportunity zone investment is held:
Investments held at least five years receive a basis step-up equal to 10 percent of the capital gain; and
Investments held at least seven years receive an additional basis step-up equal to 5 percent of the capital gain.
Second, capital gains from the opportunity zone investment are tax free if the investment is held at least 10 years.
For example, a person buys stock in a public company for $1 million, sells it two years later for $1.5 million, and realizes a capital gain of $500,000. Ordinarily, the taxpayer would owe $119,000 in tax now – 20 percent capital gain tax plus 3.8 percent net investment income tax. If the initial $500,000 capital gain is invested in an opportunity zone fund, the $119,000 tax liability would be deferred until shares in the fund were sold or December 31, 2026, whichever is earlier.
If the investor holds the opportunity zone investment for five years, the tax liability on the original $500,000 capital gain will be 10 percent less, or $107,100. If he or she holds it for seven years, it will be 15 percent less: $101,150. The investor would owe less tax on the same original gain because the profits were invested in an opportunity zone fund, and the taxes on that original gain would be paid later in dollars that are worth less due to inflation.
If the investor holds the opportunity zone investment for 10 years, its cost basis would increase from $500,000 to its fair market value at the time it is sold. Any gains from the sale of the opportunity zone investment would be tax free.
Special Rules Apply
Investments in opportunity zones are subject to many rules and restrictions, most of which are in two sets of Treasury Department proposed regulations issued October 2018 and May 2019. There are, however, some basic guardrails that ensure the investments serve their purpose of economic development and job creation in low-income communities.
- Qualifying capital gains are not reinvested directly in opportunity zones but rather through qualified “opportunity funds.” An opportunity fund must conduct business in an opportunity zone, either directly or indirectly.
At least 90 percent of an opportunity fund’s assets must be invested in qualified opportunity zone “property.” This is defined as tangible property used in a trade or business that is operating in the opportunity zone, or shares in a subsidiary corporation or partnership that conducts business in the opportunity zone.
The 90 percent rule is tested every six months. An opportunity fund that fails to comply will be assessed a penalty.
Opportunity funds cannot invest in golf courses, private clubs, massage parlors, hot tub facilities, tanning facilities, racetracks, casinos, or liquor stores, and they cannot invest in other opportunity funds.
Tracking Opportunity Zone Investments
There is no single source tracking opportunity zone investments. Language in TCJA included reporting and data collection requirements to study the impact of these investments, but the provisions were struck on a Byrd rule violation. However, efforts are underway to fill the information void:
Treasury and IRS have published a request for information seeking comments on how to track and assess opportunity fund investments.
Senators Tim Scott and Cory Booker have introduced legislation – S. 1344 – that would restore and enhance the metrics from the original version of TCJA.
The private sector has begun developing its own platforms for data reporting.
Anecdotal evidence suggests that most opportunity zone investments so far have been in real estate, but the recent Treasury regulations should provide enough clarity to accelerate other investments. Recent examples include:
East Chicago, Indiana, announced a $26 million superfund site cleanup, financed with opportunity zone funding, that will be redeveloped as a logistics center.
A Habitat for Humanity project in Charlottesville, Virginia, will redevelop a mobile home park into a mixed-income neighborhood with affordable housing and small businesses.
St. Paul, Minnesota, will use opportunity zone investment to complete the development of a shopping center and health clinic that was stalled by the 2008 recession.
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