There's potential gold in the Opportunity Zone program, but investors need to know the rules to realize a windfall.
More than 80 Opportunity Zone funds representing billions of dollars have been established since the government launched the Opportunity Zone program in January 2018. Created by the Tax Cuts and Jobs Act of 2017, the program is designed to bring dollars into underinvested areas while offering a path for investors to deploy unrealized capital gains -- estimated at nearly $6 trillion -- into any of the 8,700 census tracts designated as Opportunity Zones in exchange for deferred or reduced taxes.
Our firm is helping individuals, corporations and partnerships set up OZ funds, which must adhere to strict guidelines dictating where, when and how the money can be deployed. Opportunity Zone benefits won't turn a bad deal into a good one. And, perhaps most importantly, investors need to understand the nuances of the program to ensure they get hoped-for tax deferrals or breaks.
Some areas of confusion are:
1. What qualifies as a capital gain
A capital gain can be from real estate, stock or other assets, but it must arise from a sale between Dec. 22, 2017, and Dec. 31, 2026, and be invested in a Qualified Opportunity Fund (QOF) within 180 days of the gain recognition date in order to qualify.
Sales to a spouse, child or other relative, or a trust set up to benefit such people, would not qualify, nor would a sale to a corporation if the seller owns 20 percent or more of its shares.
2. How long you have to invest the capital gain
Investors have 180 days from the day the gain is realized to invest in a fund. Then, the fund may have as many as 180 additional days before it must invest the money. You also can form your own closely held fund without third-party investors, which can buy you up to another six months.
3. How much of the QOF must be invested in the Opportunity Zone
A QOF needs to invest more than 90 percent of its assets in a property or business within the Opportunity Zone. A business qualifies if "substantially all" -- defined as 70 percent -- of its property is located within zone boundaries. Under these parameters, the minimum amount required to be invested in eligible property would only be 63 percent.
After the initial tax year, the IRS will measure the amount invested twice a year -- on June 30 and Dec. 31 -- and if you fall below the required amount, you will be penalized.
4. What properties you can invest in
Properties must be newly constructed or "significantly rehabbed" within 31 months. In order to qualify, the renovation must be equal to the cost of the property itself (but not the underlying land). The property itself can be commercial or residential but can't be a "sin property," such as a liquor store or massage parlor.
5. How taxes are handled
If you invest in a QOF prior to Dec. 31, 2019, you may defer paying taxes on the original capital gain until divestiture or Dec. 31, 2026, whichever comes first. If you hold the investment for five years, you pay tax on 90 percent of the original gain; if you hold it for seven years, it's 85 percent. However, since the original gains are taxed no later than Dec. 31, 2026, you need to invest gains no later than Dec. 31, 2019, to get the maximum tax benefit.
While your initial QOF investment will ultimately be taxed, you do not have to pay any capital gains tax on appreciation from the investment as long as it's held for 10 years.
Besides spurring investment in distressed areas, Opportunity Zones offer investors a way to reduce their capital gains tax burdens. Still, questions about the program remain as the IRS works toward final guidance on how exactly it will work. In order to fully realize the many benefits, investors must first take time to learn the ABCs of OZs while staying abreast of changes that may influence their ultimate investment strategy.
• Darryl Jacobs is a founding partner of Ginsberg Jacobs LLC, a Chicago-based law firm.