An Introduction to the Newest Incentive Program

The Tax Cuts and Jobs Act, passed in December 2017, includes certain tax incentives for investors engaged in the development of a Qualified Opportunity Zone through a qualified Opportunity Fund.  The goal of this legislation was to spur private investment in distressed areas.  Under the program, investors may reinvest capital gains from other sources in an Opportunity Fund in exchange for deferred, preferential or exempt tax treatment on historic and future capital gains.  This article will briefly summarize what a Qualified Opportunity Zone is and the benefits of investing in such an area through a Qualified Opportunity Fund.

What is a “Qualified Opportunity Zone” and where are they in New Jersey?

Subchapter Z of the Tax Cuts and Jobs Act provides the basis for the Qualified Opportunity Zone Program.  The law provides each state the chance to nominate census tracts to be designated as a Qualified Opportunity Zone.  On March 10, 2018, Governor Murphy submitted a list of 169 census tracts to the U.S. Treasury.  On April 9, 2018, the Treasury Department released the full list of approved census tracts, which included all 169 census tracts nominated by Governor Murphy.  An interactive map, a list and other information regarding New Jersey’s Qualified Opportunity Zones is available at: http://www.state.nj.us/dca/divisions/lps/opp_zones.html

What are the Benefits to Investing in a Qualified Opportunity Zone?

As stated above, in order to participate in the program one must invest capital gains into a Qualified Opportunity Fund.  More detail about Opportunity Funds is included in the next section of this article.  Following the investment in an Opportunity Fund, investors will experience three types of tax benefits, depending on the length of time such Opportunity Fund investment is held:

1.      First, in exchange for reinvesting capital gains in an Opportunity Fund, the investor receives a short-term deferral of inclusion in taxable income for such capital gains.  This deferred capital gain must be recognized on the earlier to occur of (i) the date on which the Opportunity Fund investment is sold or exchanged, or (ii) December 31, 2026.

2.      Additionally, investors in an Opportunity Fund will receive a step-up in basis for capital gains reinvested in an Opportunity Fund.  The applicable basis in the deferred capital gain is increased by 10% if the investment in the Opportunity Fund is held for at least 5 years, and by an additional 5% if the investment in the Opportunity Fund is held for at least 7 years.  Thus, it is possible to achieve a step-up in basis equal to an aggregate of 15%, resulting in the exclusion of such amount from taxation.

3.      Finally, if an investor in an Opportunity Fund holds such investment for at least 10 years, the capital gains associated with the sale or exchange of the investment in such Opportunity Fund will be permanently excluded from taxable income (technically, the statute provides that the basis shall be equal to the fair market value of such investment on the date the investment is disposed of).  Note that this permanent exclusion does not apply to the capital gains achieved prior to the investment in the Opportunity Fund (i.e., permanent exclusion is only available for Opportunity Fund investment capital gains).

By way of example, if an investor has $1,000,000 of capital gains, and that $1,000,000 is reinvested into an Opportunity Fund and the investment is held for 10 years or more, (i) the capital gains tax due on the $1,000,000 can be deferred until December 31, 2026, and (ii) the investor’s basis relative to the original capital gains would be increased by 15% (i.e., the investor would have taxable income of $850,000, not $1,000,000).  Finally, because the Opportunity Fund investment is held for 10 years or more, the investor does not owe capital gains tax on the appreciation of the investment in the Opportunity Fund.

How Do I Participate?

Making use of the Qualified Opportunity Zone program requires that investors reinvest capital gains in a Qualified Opportunity Fund (i) within 180 days of the sale or exchange resulting in capital gains and (ii) in advance of December 31, 2026.  A Qualified Opportunity Fund is an investment vehicle organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (which includes Qualified Opportunity Zone Stock, Qualified Opportunity Zone Partnership Interests, and Qualified Opportunity Zone Business Property).  The Qualified Opportunity Fund must hold at least 90 percent of its assets in qualified opportunity zone property or significant penalties apply for each month in which noncompliance continues.  Important to note, in order to be considered Qualified Opportunity Zone Business Property the law requires that “the original use of such property in the qualified opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund substantially improves the property.”  This requirement is meant to discourage “buy and hold” strategies, and instead seeks to spur redevelopment and substantial improvement in Qualified Opportunity Zones.

At this stage there remains uncertainty regarding the oversight that Qualified Opportunity Funds will be subject to. However, the IRS has provided a set of “Frequently Asked Questions” that indicates eligible entities will be able to self-certify to become a Qualified Opportunity Fund by filing a form (which is anticipated to be released this summer).  The self-certification form would be filed with the entity’s annual federal income tax return.  

Summary

In the wake of the Great Recession, the United States and New Jersey (and its residents) have experienced significant economic success.  In connection therewith, many will find that they have capital gains from the growth of stocks and other assets.  Such capital gains may be eligible for preferential treatment if the capital gains are reinvested into a Qualified Opportunity Fund.