by Mario Fazio, Esq.
Many areas in the United States have economically distressed communities, represented by low-income households, underwhelming job opportunities, and underdevelopment. More locally, Cleveland, Ohio may be one of the most distressed big cities in America, according to a study conducted by the Economic Innovation Group. In a study released in 2017, the group used U.S. Census data to document how growth is stagnant in much of the country. To address distressed communities nationally, Congress established a new community development program to incentivize investments in these areas. The new program was established by the enactment of the Tax Cuts and Jobs Act of 2017 and encourages long-term investments in areas designated as Opportunity Zones (“OZ”) through tax incentives as discussed below.
Regions qualify as an OZ through a nomination process conducted by the governor of each state and certification by the U.S. Treasury Secretary. In Ohio, there are 1,280 low-income communities (LIC) tracts identified by the state. Congress imposed a 25 percent limitation on the number of LIC tracts that any given state may nominate for OZ certification. The tracts nominated for OZ certification take into account recommendations of municipalities and other local governments. Ohio has certified OZs in 73 counties. In Cuyahoga County, downtown Cleveland, West 25th Street, University Circle, and other significant portions of the county are designated as OZs. Here is link to the OZ map for the U.S.: https://development.ohio.gov/bs/bs_censustracts.htm.
The following Q&A explains how the Opportunity Zone investment and tax incentives works.
- What is the OZ Investment Tax Incentive?
The primary tax incentive is somewhat complex because it is available to an investor who “rolls-over” capital gain realized from the sale of an asset by reinvesting such gain in an opportunity zone (“OZ”) fund. The tax incentive is available to investors who (1) sell an appreciated asset and (2) reinvest cash equal to the amount of the gain on the sale in an OZ fund within 180 days. The roll-over of the gain into an OZ fund results in the deferral of the payment of tax on the sale. The deferred tax is effectively “redirected” to the taxpayer’s investment in the OZ fund. Thus, capital that is currently held in appreciated investments or other assets may be sold and the amount of the gain on the sale may be reinvested into an OZ fund to qualify for tax deferral.
In addition to tax deferral on the sale of an appreciated asset, there are further tax incentives that are largely driven by the length of time that the investor holds the OZ investment. Most importantly, if the investor holds the opportunity zone fund investment for at least 10 years, any post-acquisition appreciation on the OZ roll-over investment is permanently excluded from tax when the investment in the OZ fund is sold.
- What Property Sales are Eligible for Roll-Over Investment into an OZ fund?
The primary tax incentive for making an investment in an OZ fund is the deferral of tax arising from a taxable sale of one or more capital assets by a taxpayer. If a qualifying OZ investment is made within 180 days of the sale by the taxpayer, the taxpayer effectively may “roll-over” the tax into the OZ investment. As an example, assume a taxpayer sells land for $4,000 and realizes taxable gain on the sale of $2,000. If the taxpayer invests $2,000 in cash in an OZ fund within 180 days of the sale date, the taxpayer defers the payment of tax on the gain. If the taxpayer was otherwise subject to a 25% tax rate on the sale gain, the taxpayer effectively “saved” $500 of tax by making the investment and the OZ investment only “cost” the taxpayer $1,500 ($2,000 investment, less $500 of tax deferral).
Only property sales to unrelated persons that occur on or after January 1, 2018 are eligible for roll-over into an OZ fund. The tax on the gain is not permanently avoided, but is deferred until the earlier of 2026 or the date that the OZ investment is sold. The sale of real estate, securities or other assets that result in taxable capital gain are all eligible for roll-over treatment, although further guidance is required to determine whether other types of gain, including depreciation recapture realized on the sale, are eligible for OZ investment. Moreover, the statute does not require any minimum holding period for the asset that is sold, so both short-term and long-term gain should be eligible for roll-over into an OZ fund.
- What is an OZ Fund?
There are specific requirements to qualify as an OZ fund. First, the OZ fund must be organized as a corporation, LLC or a partnership. In deciding the type of entity, consideration should be given to the normal income tax rules that apply to partnerships, C corporations or S corporation since those tax regimes will apply to the OZ fund and its investors as applicable. Second, the OZ fund must be organized for the purpose of investing in qualified OZ property (other than another OZ fund), which is further discussed below. Third at least 90% of the assets of the OZ fund must consist of qualified OZ property as measured on two semi-annual testing dates each year (i.e., on the last day of each of the sixth and twelfth month of the taxable year of the fund).
- What is OZ Property?
The key to establishing an OZ fund is the OZ property requirement, since on a going forward basis at least 90% of the fund’s assets must be OZ property. OZ property includes both tangible business property meeting certain requirements as discussed below, as well as investment in one or more subsidiaries conducting an OZ businesses.
a. Qualified OZ Business Property. It is critical that an OZ fund strictly observe the OZ property requirements to avoid loss of the OZ tax benefits. Also, noncompliance can result in some cases in a tax penalty, as discussed further below. The statute’s goal of spurring new investment in OZs rests in the definition of OZ business property, which is defined as tangible personal property used in the business that meets the following additional requirements:
i) purchased by the fund on or after January 1, 2018
ii) is new property or used property (but if it’s used property the fund must “substantially improve the property”); and
iii) used by the fund in the OZ during substantially all of the fund’s ownership period.
If the OZ fund holds the property directly, the fund will be the owner and operator of the OZ business. Alternatively, as discussed further below, the OZ may conduct the OZ business through a subsidiary entity.
b. Beware of Related Party Rule. Investors that currently own property or businesses located in an OZ may desire to redevelop this property or reinvest in the business and take advantage of the OZ tax benefits. However, it may be difficult to structure transactions involving property currently owned by potential investors, because the OZ fund is generally prohibited from acquiring property from related parties. For this purpose, a person is considered related if the person owns more than 20% of the fund. There are controlled entity and family attribution rules that apply in determining whether this 20% threshold is crossed. If the OZ fund purchases property from a related party, the property will not qualify as OZ business property and the OZ fund status may be in jeopardy. Remember that 90% of the OZ fund’s assets must consist of qualified OZ property. For pre-owned property, it may be permissible to structure alternative transactions such as operating leases or ground leases of property to the OZ fund, and have the OZ fund make the reinvestment in the business or properties.
c. Beware of Capital Contributions of Property to OZ Fund. For property to qualify as OZ business property, it must be purchased by the OZ fund. Similar to the related party rules set forth above, a transfer of business assets or property that is located in an OZ as a capital contribution to an OZ fund is prohibited since it is not considered to be “purchased” by the OZ fund. Again, alternative structures may need to be explored, including lease transactions or a purchase of such property as long as the seller is not a related party.
d. Used Property that is Substantially Improved by the OZ Fund. The purchase of used property may qualify as OZ business property if it is purchased by the fund on or after January 1, 2018. However to qualify, the fund must improve the used property in an amount in excess of the original cost of the property and such improvements must be completed within 30 months of the acquisition date. This rule will apply to most existing OZ properties that are purchased by OZ funds from unrelated persons.
- OZ Subsidiaries
As mentioned above, an OZ fund may directly own OZ business property and conduct the OZ business, or it may invest in subsidiary entities that qualify as OZ property. Under this structure, the OZ subsidiary would be the entity that conducts the business and owns the OZ business property. The OZ fund would hold an ownership interest in the subsidiary. For the investment in the subsidiary to constitute qualified OZ property the following requirements must be met:
a. The fund acquires some or any portion of the stock in the corporation, or interest in the LLC or partnership directly from the issuing corporation, LLC or partnership, as the case may be, in exchange for a cash investment by the fund. There is no minimum percentage ownership requirement.
b. The OZ subsidiary conducts (or intends to conduct) a trade or business in which substantially all of the tangible property owned or leased by the OZ subsidiary is OZ business property (i.e., tangible personal property used in the subsidiary’s business that is purchased by the subsidiary on or after January 1, 2018, is new property (or used property, but “substantially improved” by the subsidiary within the 30-month period following acquisition), and used by the subsidiary in the OZ during substantially all of the subsidiary’s ownership period).
c. At least 50% of the total gross income of the subsidiary is derived from the active conduct of such business.
d. A substantial portion of the intangible property of the subsidiary is used in the active conduct of such business
e. Less than 5% of the subsidiary’s assets is attributable to nonqualified financial property.
f .The subsidiary’s business is not a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
- Should the OZ Fund Own Business Directly or Through Subsidiary?
If the OZ fund owns the business directly, at least 90% of assets must consist of tangible property used in the business in the OZ. This rule is restrictive since it allows not more than 10% of the total assets of the fund to consist of assets not used in the business, including cash and assets held for investment that are not used in the business. Keep in mind that a penalty applies in the event that the 90% investment standard is not met. The penalty can be substantial if the shortfall in significantly below 90%. However, a similar restriction does not apply if the OZ funds places all of its assets in an OZ subsidiary as long as substantially all of the subsidiary’s tangible property is used in an OZ business. The OZ subsidiary must also meet the additional requirements set forth above, including that a “substantial portion” of its intangible property (e.g., cash, working capital, and investment securities) be used in the business. On balance, the use of an OZ subsidiary to operate the business appears to provide greater flexibility compared to the OZ fund operating the business directly.
- Tax Deferral.
The capital gain on the asset sale will be deferred until the earliest occurrence of the following: the date the investor disposes of its OZ fund interest or December 31, 2026. If the interest is held for at least five years, then the amount of gain ultimately subject to tax is reduced by 10 percent. If the interest is held for at least 7 years then there is an additional 5 percent reduction on the amount of gain, for a maximum 15 percent reduction. Lastly, the investor will not recognize any gain on the post-acquisition economic appreciation in its OZ fund interest if the interest is held for at least 10 years. It should be kept in mind that these basis adjustments and exclusion of gain after 10 years applies only to the OZ fund interest that was acquired with the roll-over gain proceeds. If amounts are invested in the OZ fund that are in excess of the roll-over gain, then that portion of the investment is not eligible for the basis adjustments or gain exclusion.
- Tax Penalty if 90% Investment Standard Not Met.
The OZ fund is required to maintain an investment standard that consists of at least 90% of its assets as OZ property (i.e., OZ business property, or investment in OZ subsidiaries). To the extent that the assets of the OZ fund are less than this investment standard, the OZ fund is subject to a monthly penalty equal to the amount of the shortfall multiplied by the underpayment rate for such month. As of the date of this writing, the underpayment rate is 5%. On its face, the penalty amount is egregious since it accrues at the rate of 5% per month (e.g., 60% over a 12-month period). If this penalty rate is not reduced by regulation or by an amendment to the statute, it will be critical that the 90% investment standard be closely watched to avoid the penalty.
The OZ fund tax incentive appears to be a very useful incentive for investment in OZs and appears to be flexible enough in most commercial settings that it should be seriously considered in structuring new investments in any OZ. Certainly, the related party rule and the restriction on tax-free transfers of property to an OZ fund create some structuring obstacles, although there appear to be alternative structures that may still work in such settings. Finally, close attention will need to be paid to the 90% investment standard, which in many cases may lead most transactions to use an OZ subsidiary as the entity to own the OZ business.