A “New Incentive” Investing in an Opportunity Zone
Here’s something to think about for your investor clients:
I read the most irresponsible article the other day in what would be considered a creditable publication. Before I get started, I want to point out that this article is not meant to be political in any way.
In 2000 the New Markets Tax Credit (NMTC) was established. Here’s how it worked: A Community Development Entity (CDE) was established as a domestic corporation or partnership that is an intermediary vehicle for the provision of loans, investments, or financial counseling in Low-Income Communities (LICs).
The benefits of being certified as a CDE include being able to apply to the CDFI Fund to receive an NMTC allocation to offer its investors in exchange for equity investments in the CDE and/or its subsidiaries OR being able to receive loans or investments from other CDEs that have received NMTC allocations.
To become certified as a CDE, an organization must submit a CDE Certification Application to the Fund for review. It must:
- Be a legal entity at the time of application
- Have a primary mission of serving LICs and
- Maintain accountability to the residents of its targeted LICs
The Empowerment Zone Program consisted of three US congressional designations. The Renewal Communities (RCs), Empowerment Zones (EZs) and Enterprise Communities (ECs) are highly distressed urban and rural communities that may be eligible for a combination of grants, tax credits for businesses, bonding authority and other benefits. “Highly distressed” refers to communities that have experienced poverty and/or high emigration based upon definitions in the law.
These designations were awarded in three competitions that have taken place since 1994. The Community Renewal Tax Relief Act of 2000 authorized the creation of 40 renewal communities and created the NMTC Program, which originally ended on December 31, 2011. However, on February 1, 2013, the Joint Committee on Taxation extended the program for another two years, to December 31, 2013. The Protecting Americans from Tax Hikes Act, signed into law on December 18, 2015, later extended the program through the end of 2016.
This program was primarily managed through partnerships between the local entity and either the Department of Housing and Urban Development (HUD) for RCs and urban areas or the US Department of Agriculture (USDA) for rural EZs and EC
At the time, there were 40 HUD RCs, 28 in urban areas and 12 in rural communities. There are 30 HUD EZs, all of which are in urban areas. There are 10 USDA EZs and 20 USDA ECs in rural communities. A couple RCs have as few as approximately 100 businesses, while several RCs and EZs have more than 5,000 businesses. No RC, EZ or EC has a population greater than 200,000.
Now, back to the article I read, which seemed to be written by someone who decided to not do their homework. Apparently, in 2015, a friend of the current president decided to build in one of these EZs. No problem there, however, the article went on to say that the Qualified Opportunity Zone tax incentive was enacted particularly for this friend.
Before the TCJA, you were allowed to make a like-kind exchange of property held for business (IRC §1031). For example, if you were selling the assets of your company, you could 1031 those into a new like-kind property, thus avoiding capital gains tax. The TCJA defined IRC §1031 as restricted to real estate transactions only.
TCJA legislation adopts an important and unheralded new tax incentive program called Qualified Opportunity Zones in a new IRC §1400Z. Due to the broad base of potential investors and eligible projects, properties and transactions, this program has the ability to provide substantial returns to investors, administrative opportunities for funds and subsidies for eligible projects and businesses.
These zones will be designated through a nomination of census tracts qualifying as “low-income communities.” Each state may nominate no more than a number of “qualified opportunity zones” that is equal to 25 percent of the designated “low-income communities” in each state.
States may also nominate census tracts contiguous with “low-income communities” if the median family income in the designated census tract does not exceed 125 percent of the qualifying contiguous “low-income community.” The new provision allows taxpayers to defer the short- or long-term capital gains tax due upon a sale or disposition of property if the capital gain portion is reinvested within 180 days in a “qualified opportunity fund.”
If the investment is maintained in the fund for five years, the taxpayer will receive a step-up in tax basis equal to 10 percent of the original gain. If the investment is maintained in the “qualified opportunity fund” for seven years, the taxpayer will receive an additional five percent step-up in tax basis.
A recognition event will occur on Dec. 31, 2026 in the amount of the lesser of:
- the remaining deferred gain (accounting for earned basis step-ups) or
- the fair market value of the investment in the “qualified opportunity fund”
Because of the recognition event trigger, several structuring opportunities may be available to increase basis step-ups, quite substantially in some cases. Importantly, investments maintained for 10 years and until at least Dec. 31, 2026 will allow for an exclusion of all capital gains from the post-acquisition gain on the investment in a “qualified opportunity fund” that is to be excluded from gross income.
For an investment maintained longer than 10 years and upon a sale or disposition of the investment, the new provision also allows the taxpayer to elect the basis to be equal to the fair market value of the investment.
“Qualified opportunity funds” will be determined by the Community Development Institutions Fund of the Treasury Department in a process similar to allocation of NMTCs to “community development entities.” The funds must maintain at least 90 percent of their assets in “qualified opportunity zone properties,” including investments in “qualified opportunity zone stock,” “qualified opportunity zone partnership interest” and “qualified opportunity zone business property.” The qualifications encompass investments in new or substantially improved, tangible property, including commercial buildings, equipment and multi-family complexes, with a common requirement that such investments be made in qualified opportunity zones.
So, any long- or short-term capital gain can either be deferred, as was the case with an IRC §1031, or eliminated, provided you invest for a certain amount of years (forget whether you make money or not).
The reporter went on to claim the TCJA, particularly the Opportunity Fund, was written for the current administration’s friends and business associates.
My rule is that if more than 60 percent of the funding that comes in is used for administrative costs, I don’t contribute and neither should your clients.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...