By Vadim D. Ronzhes, Esq., CPA
From the July/August 2022 Issue
The Qualified Opportunity Zone program is historically one of the nation’s largest and most ambitious public intervention programs that was created as part of the 2017 Tax Cuts and Jobs Act. The program aims to incentivize private investors to realize capital gains in the broader market in exchange for near-term and long-term tax benefits by reinvesting those gains in real estate development and operating business activities in designated low-income communities. A recent study reported that in 2019 and 2020 approximately $41.5 billion dollars of investment were made in Opportunity Zones.
The legislation, which was introduced with Democratic and Republican support, was broken into two parts. The first part authorized each state to designate 25% of the low-income census tracts in the respective state as Qualified Opportunity Zones. To put in perspective, half of the approximately 74,000 census tracts in the U.S. were eligible for selection based on the income and poverty criteria. Out of those tracts, 8,764 were designated as Qualified Opportunity Zones by states, which equates to about 12% of the entire country. The second part of the legislation provided tax incentives to investors.
The investor benefits can be split into two categories: deferral of the current tax obligation, and a tax-free sale of the investment. To participate in the program’s benefits, the investment must come from capital gains. These gains can come from a sale of a variety of assets including, but not limited to, securities, real estate, collectibles, cryptocurrency, or closely held businesses. Additionally, if the investor has an interest in a partnership or an S corporation, flow-through capital gains, including gains from the sale of business property, can be eligible for reinvestment.
Those who timely invest these capital gains into a Qualified Opportunity Fund can defer paying capital gains tax until December 31, 2026. A Qualified Opportunity Fund (QOF) is the mandatory investment vehicle, and a direct investment in a project using an alternative form would not work. Unlike other deferral programs, there is no traceability requirement—meaning that the cash for the investment can come from sources besides the gain itself such as ordinary income, savings, or debt. Investors who made their investment early were entitled to a 10% reduction of the capital gain when reaching a five-year hold, and additional 5% reduction when reaching a seven-year hold, as long as that hold was met by December 31, 2026.
If the investment in a QOF is sold before December 31, 2026, the deferred gain becomes due that year. The regulatory provisions provide an option, which is becoming increasingly more relevant in a volatile market, that if the fair market value of the investment is less than the invested gain that deferred gain may be decreased to reflect that decrease in value as of the end of 2026.
After the investor has held its investment for 10 years, any gain on the appreciation of the QOF investment will be tax-free when the investment is sold.
The effect of the foregoing tax incentives is to enhance the after-tax rate of return. In many cases, the after-tax internal rate of return for a typical investment deal will be increased by 25-50% based solely on the benefits under the Opportunity Zone program as compared to an identical investment without such tax benefits.
Legislation introduced in April 2022 aims to impose new reporting requirements that promote transparency on whether statutory requirements are met.
With increased investment in normally underperforming markets and due to novelty of the program there are risks. The QOF and the underlying investment have regular compliance obligations during the funding, development, and operating stages. The QOF must maintain a 90% investment standard by certifying that 90% of its assets are in Qualified Opportunity Zone property. Generally, that will be easy because the only activity that will occur at the QOF level is investment in another company that conducts a trade or business. The company itself will have to meet regular tests showing money is being used to improve assets, create employment activity, not holding disallowed financial assets or participating in prohibited activities, directly or indirectly, inside the Opportunity Zone. Failing to comply with any of the requirements, may cause the entire investment to not qualify for the tax benefits.
Real estate investments have a relatively predictable life cycle and cash flows. The investments benefit from a developed robust market that readily attract buyers at market prices. Meeting the regulatory standards for real estate companies is more certain because all activity, development, and operations, occur within the Opportunity Zone. On the other hand, investments in the operating business are more unpredictable, and the ability to benefit from the Opportunity Zone is not assured since it requires the convergence of many factors at the right time. Also, compliance for an operating business may be more challenging because operations may require having employees and assets in and out of an Opportunity Zone.
When choosing a QOF investment, it is important to make sure the fund provides a clear investment strategy, strong governance, reasonable fees, and adequate funding. The Opportunity Zone benefits may make sound investment better, but will never make a bad investment good.
A group of bipartisan senators and representatives in April 2022 introduced legislation that may impose new reporting requirements to promote transparency to address concerns from certain communities on whether statutory requirements and intent of the program are being met. Notwithstanding, due to the program’s inherent benefits and utilization, the proposal included an extension of the deferral period to December 31, 2028.
Whether or not an investment is the right fit will depend on the investor’s strategy, liquidity needs, and risk tolerance. Before making an investment, it is vital to make sure due diligence is performed to ensure that the investment will meet the regulatory requirements and return hurdles. As future legislation could impact the program, it is important to stay informed.
Ronzhes is a Strategic Tax Advisor at Rosen, Sapperstein & Friedlander, LLC, where he provides business advisory and tax structuring for businesses and families. Additionally, he develops strategic operational and tax plans for large clients and business transactions such as merger and acquisitions, restructuring and opportunity zones. Ronzhes is a CPA with substantial experience in compliance matters such as audits, reviews, compilations and tax returns. He is licensed to practice law in Maryland.