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As part of the Tax Cuts and Jobs Act of 2017, Congress established a new investment vehicle known as Qualified Opportunity Funds (O-Funds). This program has the potential to tap into trillions of dollars in unrealized capital gains that can be used to invest into qualifying businesses and real estate.
The program directs investment into qualifying geographic areas called Qualified Opportunity Zones (QOZ) through the O-Funds. Taxpayers that invest capital gains into O-Funds will receive a number of tax benefits for investing in these funds. In turn, the O-Funds will invest into eligible business property located in QOZs.
The program directly targets unrealized capital gains by providing three key tax benefits. Within 180- days of realizing a capital gain, an investor may now roll over the capital gain amount directly into an O-Fund and become eligible for the program's benefits:
In order to receive these benefits, the taxpayer must invest in an O-Fund, which is required to invest in QOZs.
QOZs are the driving force behind this program. In early 2018, state and territorial governments submitted qualifying census tracts to the U.S. Department of the Treasury for certification as an opportunity zone. Census tracts needed to meet certain thresholds to be eligible for certification, and each state or territory could only submit 25% of all qualifying tracts.
Eligible areas were determined at the census tract level, and the requirements for eligible census tracts are pulled from the New Market Tax Credit (NMTC) program. Tracts were eligible to be designated as a QOZ if they met one of the following requirements:
On June 14, 2018, the treasury completed the certification process for alI 50 states and U .S. territories. The statute only calls for a one-time designation, so for now, these tracts are final.
O-Funds are "investment vehicle[s] organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property". Taxpayers will also be able to self-certify as an OFund by completing a form and attaching it to their federal income tax return. The form is expected to be released Summer 2018.
Treasury is currently working on additional guidance for O-Funds, which should be released some time in Summer 2018. In April 2018, IRS released "FAQs" on the program regarding QOZs and OFunds which can be found here. The fund must meet the criteria outlined in the statute and forthcoming guidance.
O-Funds must hold 90% of assets in QOZ Property. The percentage is determined by the average on two test dates:
Penalties apply for non-compliance. The penalty is calculated using the federal short-term rate plus 3%. It is assessed for the months of non-compliance and is based only on the shortfall.
Assume that a taxpayer sells an asset on November 1, 2018 with a $500,000 capital gain. The investor then decides to invest the gain into an O-Fund on January 1, 2019 (within the 180-day period). The diagram below maps out the different benefit scenarios based on different holding periods of the investment.
|ORIGINAL GAIN INVESTED IN O-FUND: $500,000|
Date Invested in O-Fund: January 1, 2019
|Holds O-Fund Investment for 3-Years and Sells for $525,000||Holds O-Fund Investment for 6-Years and Sells for $560,000||Holds O-Fund Investment for 8-Years and Sells for $700,000||Holds O-Fund Investment for 10-Years+ and Sells for $800,000|
|3-Year deferral of capital gains tax on original gain||6-Year deferral of capital gains tax on original gain||7-Year deferral of capital gains tax on original gain (max: Dec. 21, 2026)||7-Year deferral of capital gains tax on original gain (max: Dec. 21, 2026)|
|10% / $50,000 step-up in basis||10% / $50,000 step-up in basis||10% / $50,000 step-up in basis|
|Additional 5% / $25,000 step-up in basis||Additional 5% / $25,000 step-up in basis|
|Exempt from capital gains on $300,000 O-Fund investment appreciation|
The Opportunity Zone program has been compared to other programs such as New Market Tax Credit and 1031 Exchanges, but there are key differences between the programs.
The Opportunity Zone program represents a major investment opportunity and could tap into trillions of dollars of unrealized capital gains and provides powerful incentives to drive investments into Opportunity Funds. Taxpayers who take advantage of the program may receive tax defermentsnational, stepups in basis, and tax exemptions on appreciation. There are no caps on the volume of capital flowing into 0-Funds, and these funds are required to invest into Opportunity Zones. Investments can be structured to direct capital into real estate development, venture capital, business incubators, infrastructure projects, and other economic or community development efforts.