Opportunity Zone Program: Opportunity for Investors or Opportunity for Communities?

Blake Koloseike

Associate Editor

Loyola University Chicago School of Law, JD 2020

With the implementation of the Tax Cuts and Jobs Act passed in 2017, there have been several changes to the tax system. The Opportunity Zone program was a small piece of the tax reform that has recently gained more publicity. The Opportunity Zone program provides tax benefits to real-estate investors. The Trump Administration recently released definitions and rules in a package of proposed regulations.

What is an Opportunity Zone?

The Opportunity Zone program is designed to promote economic development and job creation in low-income communities. An Opportunity Zone is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. These zones are nominated by the state and then certified by the Secretary of the U.S. Treasury through the Internal Revenue Service (IRS). The first Opportunity Zones authorized by the Tax Cuts and Jobs Act were decided in April of this year. There are nearly 9,000 census tracts designated as opportunity zones. These areas range from New York and Los Angeles to rural areas and Puerto Rico. Nearly thirty-five million Americans live in these communities, according to the Treasury. Of the eligible communities, more than half of them had fewer jobs and businesses in 2015 than in 2000.

What is the difference between the Opportunity Zone Program and previous programs?

The Opportunity Zone program is different from previous approaches, such as the Empowerment Zones and Renewal Communities program, in three primary ways. First, under the Opportunity Zone program, a taxpayer must only reinvest capital gains. In prior programs, the taxpayer was required to reinvest all proceeds from the sale of assets. Furthermore, previous programs only allowed taxpayers to defer gains from sales of assets within the qualified zone. The Opportunity Zone program appears to permit other income from sale of assets outside the qualified zone, such as gains from the sale of inventory, to be deferred. Finally, investors may organize and market the opportunity funds more expansively than prior programs.

What does this mean for taxpayers?

The Opportunity Zone program encourages investment in businesses and real estate within these zones by offering a ten-year tax deferment, potential partial forgiveness and complete avoidance of capital gains taxes. This program allows for taxpayers with capital gains from most sources to defer taxes on their investments until 2026 if they use their capital gains to invest in the designated areas. Furthermore, taxpayers will be able to get a tax discount depending on the amount of time the investment is held. If the investment is held for more than five years, there is a 10% exclusion; if held for more than seven years, there is a 15% exclusion. Finally, capital gains from qualified investments that are held for at least ten years will not be taxed at all. Any entity taxable as a corporation or partnership, including limited liability companies, is eligible to elect to be a Qualified Opportunity Fund (QOF) as long as all requirements are satisfied.

Supporters of this program argue that this will help restore neighborhoods that would have ultimately been passed over by real estate investors and developers. Moreover, this program has caused billions of dollars to be put into real estate funds in hopes of capitalizing on this tax change. Treasury Secretary Steven Mnuchin has said the zones could attract $100 billion in investment.

Critics claim the program allows tax giveaways to investors and developers of projects that would otherwise have been profitable without the additional incentives. Additionally, it has been argued that this economic development will cause the people of these communities to get forced out only to be replaced by the people benefiting from this program. In that case, there will be a disparity between the size of the potential impacts and the social benefits of the investments.

What are the definitions and rules currently?

The Treasury created a proposed 70-30 rule that measures whether a business counts as having “substantially all” of its assets in an opportunity zone. Under this rule, the term “substantially all” means 70% of a business’s tangible property is in the zone. Furthermore, reasonable working capital will not be treated as “nonqualified financial property” as long as it meets the safe harbor test. There is a safe harbor of up to 31 months for reasonable working capital held by a QOZ business allowing the QOF to treat its investment in such business as QOZ property. Businesses are eligible to qualify for the tax incentive if they meet this requirement.

Additionally, the proposed rules extended the time frame to reinvest the capital gains into the zones. Prior to this, the capital gains must be reinvested within six months after the previous investment’s sale. The Treasury has given businesses an additional thirty months, so long as there is a plan for a qualifying project within the zone.

Finally, the Treasury created a rule defining the amount of improvement that must be made into a building to qualify as a new investment. The law provides that at least 100% of the property’s adjusted basis must be spent improving the property within a 30-month period in order to be considered “substantially improved.” Furthermore, existing buildings must be substantially improved by expenditures at least equal to the basis of the building within a 30-month period in order to be considered a QOZ property.

Investors are frustrated by the lack of guidance they are receiving regarding these new rules. Further, most large investors aren’t willing to commit their capital until clear rules are released to ensure some level of certainty their investments will be a success. Overall, the Opportunity Zone program of the Tax Cuts and Jobs Act is designed to promote economic development and job creation. There are few restrictions on this program leaving the program very open-ended. The impact of this program will not be known for a few years because Congress has asked the IRS to begin reporting on this program in 2022.