The Tax Cuts and Jobs Act became law on December 22, 2017. The Act is best known for its revision of individual tax rates and brackets and for setting the federal income tax rate at a flat 21% for corporations. But the Act also allowed for the creation of Opportunity Zones. For those who invest in these zones, the Act allows a deferral of gains on the investment. Also, the longer an investor holds an investment, the more gain the investor will be able to exclude from appreciation in the investment until, at the ten-year mark, there will be no gain at all.
Opportunity Zones Help Low-Income Communities
The purpose of the Opportunity Zone provisions of the Act is to encourage investment in low-income communities. There are two definitions for a low income community:
- A low-income community is a population census tract in which the poverty rate is at least 20%.
- Alternatively, a low-income community is a census tract in which the median family income does not exceed 80% of the statewide median family income, or metro area median income if the tract is in a metro area.
By these tests, the Act attempts precise targeting of economically distressed communities.
Creation of Opportunity Zones
There is a three-step process for creating an Opportunity Zone. First, a state’s governor nominates a tract to be a zone. Second, the governor notifies the Secretary of the Treasury of the nomination. Finally, within thirty (30) days, the Secretary must act on the nomination.
How Many Are There?
The Act limits the number of Opportunity Zones each state may have. The number of zones in a state is capped at 25% of the number of low-income communities within the state or, if there are no more than 100 such communities within a state, then the state may designate up to twenty-five such tracts as Opportunity Zones.
The Act extends to the District of Columbia and all five United States territories, among which is Puerto Rico. There is a special rule for Puerto Rico. Puerto Rico is not subject to the 25% or twenty-five tract limit on the number of zones. Every census-designated low-income community may become an Opportunity Zone in Puerto Rico.
The IRS website includes a list of Opportunity Zones as a downloadable spreadsheet. The list shows 8,764 Opportunity Zones in all, including in Puerto Rico, other territories and the District of Columbia. There are thirty-six zones in Manhattan and a total of 306 in the five boroughs. But an investor in an Opportunity Zone need not live in a zone. The investor need only invest in it.
Tax Advantages for the Investor
The heart of the Act lies in its treatment of gains. In short, the Act provides that for investors who invest in an Opportunity Zone, gain from the investment is excluded from gross income for each taxable year the investment is held. It is important to note the existence of a 180-day rollover period, which begins on the date of sale or exchange of the funds that the investor intends to invest in the Opportunity Zone. Also, the investor must elect with the IRS to have the income treated as a gain under the Act.
The Act expires, by its terms, on December 31, 2026. Therefore, gain from an Opportunity Zone investment is included in income on the date the investment is sold or exchanged, or as of December 31, 2026, whichever comes first.
But there are additional tax advantages, depending on how long an investor holds on to his investment. If the investor keeps the investment for at least five years, there is a 10% reduction of gain on the investment. If the investor keeps the investment for at least seven years, the reduction of gain rises to 15%. Finally, if the investor keeps the investment for at least ten years, then all gain on the investment is excluded from income on the investor’s tax return.
Investments Not Passive
Opportunity Zones are not designated for passive investment. The object of the program is to inject capital into economically depressed areas and then use the capital to improve those areas. For that reason, funds must be used to make “substantial improvements” to investment properties. The Act defines substantial improvements to mean improvements equal in value to the original infusion of capital. Per the Act, the improvements must be made within no more than thirty months of the date of investment.
Qualified Opportunity Funds
Individuals may invest in an Opportunity Zone, as may other entities. The Act also establishes “qualified Opportunity Funds,” which are entities organized for the sole purpose of investing in zones and hold at least 90% of their assets in such property.
While the usual investment will be cash, any type of property may be invested in a qualified Opportunity Fund. But if an investor transfers non-cash property to the qualified Opportunity Fund, it is possible that only part of the investment will be eligible for the Opportunity Zone tax benefits under regulations proposed by the Treasury.
Another requirement for qualified Opportunity Funds is that they must earn at least 50% of their gross income from business activities conducted within a zone. This requirement must be met every tax year. The Treasury Department has published proposed regulations that provide safe harbors for determining how to quantify business activities conducted within an Opportunity Zone. Three types of safe harbor rules are under consideration. They center on:
- How many hours of services were received in the Opportunity Zone?
- What amounts of money for services rendered were paid in the Opportunity Zone?
- Which necessary tangible property and business functions were located in or provided within the Opportunity Zone?
Status of Opportunity Zone Investment
According to the Tax Foundation, it is too early to evaluate the success of the Opportunity Zone legislation because the Treasury thus far has been unable to connect the data it has to specific census tracts. But a quick Google search for qualified opportunity funds reveals a hot market. As the Foundation says, federal officials continue to hope that Opportunity Zones will revive economically distressed communities. Apparently, investors are encouraged.
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