The 2017 Tax Cuts and Jobs Act amended the tax code to encourage economic growth and investment in designated distressed communities called Qualified Opportunity Zones. Federal income tax benefits are now provided to taxpayers who invest in businesses, known as Qualified Opportunity Funds, located within these Opportunity Zones. This is beneficial for both real estate developers looking for private financing and investors seeking opportunities to invest and grow their capital in a tax efficient manner.
The amendments to the tax code allow each state to designate investment areas as “Qualified Opportunity Zones.” Earlier this year, the governors of Pennsylvania and New Jersey designated 300 and 169 census tracts respectively, covering a wide geographic area of urban and rural areas across the states, as Qualified Opportunity Zones. In the Philadelphia area, many of these opportunity zones are adjacent or near ongoing redevelopment projects in Center City Philadelphia, with a concentration along the banks of the Schuylkill and Delaware rivers. In New Jersey, there are zones located along the Camden waterfront and in Burlington, Gloucester, and Salem counties.
The initial amendment to the tax code left several questions unanswered. Recently, the IRS published its long-awaited rules to answer these open questions. The proposed rules will allow deferral of taxation on certain gains to the extent corresponding amounts of such gains are timely invested in a partnership or a corporation organized for the purpose of investing in property located in a Qualified Opportunity Zone. A recent article in the Wall Street Journal noted that at least 43 funds are seeking to raise a total of approximately $8.9 billion, according to a list compiled by the National Council of State Housing Agencies. Treasury Secretary Steven Mnuchin expects this program to raise over $100 billion.
Benefits of Investing in an Opportunity Zone Fund
Here are the three main benefits of investing in a Qualified Opportunity Fund:
- A deferral on inclusion of capital gains reinvested in a Qualified Opportunity Fund until Dec. 31, 2026, if the investment is made within 180 days after the initial sale.
- An ability to exclude tax on up to 15 percent of the capital gains reinvested if the Qualified Opportunity Fund investment is held for five to seven years.
- Exclusion from gross income of the post-acquisition gains on investments in a fund so long as the investment is held for at least 10 years. Notably, the structure of the tax benefits creates a strong incentive to close on Qualified Opportunity Zone investments by Dec. 31, 2019.
The IRS’s recent publication of its guidance answers many questions left open by the initial tax code amendment. As a result of the proposed rules, there will be greater taxpayer certainty as to the type and timing of transactions that qualify for capital gains deferral and therefore greater use of the Opportunity Zone Program. As mentioned above, many fund managers are in the process of creating Tax-Favored Development Funds to seek out private investors to benefit from these Opportunity Zones.
Opportunities for Real Estate Developers
Real estate developers intuitively understood the powerful nature of the new Opportunity Zone legislation, but their enthusiasm was hampered without further guidance. The answer to their calls for clarity came on October 19th when the Treasury Department issued proposed regulations, as well as guidance. Developers quickly recognized that the general tenor of the newly-issued guidance is "investor-friendly" and speaks to an overall theme of driving unbridled economic activity to the targeted opportunity zones. Specifically, three key points stand out to accelerate the flow of investment into Opportunity Zones, namely (i) flexible timing to deploy capital; (ii) a less restrictive test on how measure substantial improvement; and (iii) making use of leverage to maximize development.
Business owners also have an opportunity to participate in the benefits of these Opportunity Zones. Opportunity Zones provide options for private business owners who are looking to expand their operations geographically or move to a new location due to size restrictions.
Tax Planning Opportunities
Because deferral of capital gains can be an important tax planning tool for many business owners and real estate investors that have recently sold assets at a capital gain, consideration should be given to how an investment in an opportunity zone may be beneficial to your particular financial situation. Given the wide reach of the Opportunity Zone Program, if you have recently sold a business or real estate interest and are contemplating reinvesting the capital gain, then your next investment may qualify for deferral of taxes owed on the gain.
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