The Opportunity Zone program established under The Tax Cuts and Jobs Act, signed into law in December 2017, and codified in new IRC Sections 1400Z-1 and 1400Z-2, offers tax incentives for those who reinvest capital gains and provide long-term investments (in real estate and/or operating businesses) in designated community census tracts. To date, the designations have been made in all 50 states, creating more than 8,700 designated census tracts throughout the United States, referred to as “Qualified Opportunity Zones.” In New Jersey, at least one designation was made in each of New Jersey's 75 municipalities. Interactive maps detailing the zones in New Jersey can be found on the State of New Jersey Department of Community Affairs website, https://www.state.nj.us/dca/divisions/lps/opp_zones.

The bipartisan legislation, sponsored by Cory Booker (D-N.J.) and Tim Scott (R-S.C.) has been heralded as a program with potential to become one of the most impactful federal incentives for encouraging capital investment in low income, distressed communities ever to be enacted.

Tax Advantages

Under the program, investors benefit from a deferral of capital gains tax, a shallow abatement of that tax and an abatement of tax on the appreciation of the original investment, so long as the gain is reinvested within 180 days from realization in a Qualified Opportunity Fund (as defined in the statute and referred to herein as a QOF). The tax benefits are tiered based on the length of timing of reinvestment at five, seven and 10 years.

The tax on the initial capital gains investment is determined as the lesser of the amount of gain deferred or the fair market value of the investment minus the taxpayer's basis in the QOF. The taxpayer's basis in the QOF is initially deemed zero. The statute provides partial forgiveness of the tax deferred. If the investment is maintained in the QOF for five years, step-up of the basis of the initial capital gain investment is 10 percent. For investments maintained for seven years, the investor gets an additional 5 percent step-up, totaling 15 percent forgiveness of the tax deferred. It remains unclear what tax rate will apply to the deferral, whether taxed at the rate at year of deferral or year of inclusion. There is no tax on the appreciation of the initial investment upon sale or exchange of the QOF so long as the investment in question is held for 10 years or longer.

Absent guidance on the inconsistent dates set forth with respect to termination of the QOZ designations (Dec. 31, 2028), the outside deferral expiration date (Dec. 31, 2026) and the holding periods (five, seven and 10 years), the tax advantages can be summed up as follows:

• Tax on the capital gain invested is deferred until the earlier of sale of the investment or 2026;
• Capital gain must be invested in a QOF within 180 days of realization;
• If reinvesting eligible capital gain from 2019 but before 2022, it is not possible to hold for seven years. The gain is deferred but the basis reduction is only available up to 10 percent. The 15 percent will not be available; and
• If reinvesting after 2021, the gain will be deferred but no step-up will be available (as it does not meet the five-year hold test).

Compliance

The statute sets forth the parameters of the investment that must be met to qualify for the tax advantages. In summary:

To qualify for tax advantages of the program, reinvestment of capital gain must be through a QOF. Per the language of the statute, a QOF must be a partnership or corporation. It is unclear whether a QOF could be an LLC. General consensus is that as long as a limited liability company is classified as a partnership for tax purposes, then such limited liability company should be an acceptable QOF vehicle.

The QOF's must be certified. FAQs released in April indicate that certification will be made simply by filing a form with a timely filed federal income tax return for the tax year. However, at this time, there is no formal mechanism for certification.

QOF's must hold at least 90 percent of its assets invested in a QOZ and in Qualified Opportunity Zone Property (QOZ Property). The 90 percent test will be measured twice a year, on the last day of the QOF's taxable year and on the last day of the first six-month period of the QOF's taxable year (assume Dec. 31 and June 30). Failure by the QOF to meet the 90 percent test results in a penalty for each month not in compliance.

The QOF must acquire the QOZ Property after Dec. 31, 2017.

The QOF must acquire the QOZ Property from unrelated parties (IRC Section 179(d)(2)).

Unless the QOZ Property is “original use” in the Opportunity Zone, the QOF must “substantially improve” the QOZ Property within 30 months after date of acquisition. Per the statutory definition, to substantially improve, the QOF must expend capital in relation to the QOZ Property in an amount equal to or greater than the initial basis within the 30-month period.

The QOZ Property cannot be property used in connection with a “sin” business, defined as tanning salons, country clubs, massage parlors, hot tub facilities, racetracks or other gambling facilities, or sale of alcohol for off-site consumption.

Conclusion

As is generally the case with new tax legislation, and this legislation in particular, there is a great deal of uncertainty with respect to the practical application of the program and investment therein. In spite of the uncertainty, many investors and fund managers are already investing in the Opportunity Zones nationwide and raising pooled private equity to invest in the program. Municipalities throughout the U.S., and certainly in New Jersey, have created Opportunity Zone websites to promote the program locally, and many are considering promulgating additional incentives, by way of zoning and real estate tax abatements to foster investment.

However, the ultimate success of the program will most definitely depend on the issuance of and the timing of guidance to address and clarify, at the very least, the timing of capital deployment by the QOF, the designations of the QOZs, the 90 percent test, the substantial improvement test, acquisition post December 2017, the unrelated party rules, along with issues relating to taxation of QOF investor distributions during the holding period and deemed “redemption” of the initial capital gains investment. This much-anticipated guidance was initially expected this summer and as of the date of this article, no guidance has been released.

The good news is that the Treasury is under pressure to issue guidance from a whole host of trades and consortium groups to effectuate the investment in this program. Guidance is now on the horizon and should be forthcoming in the coming weeks in that the Office Management of the Budget has received regulatory guidance for review from the IRS.

Marcy N. Hart is a partner with Fox Rothschild in Philadelphia. She is a transactional attorney with more than 30 years of experience in real estate and corporate finance.