By Nelson A. Toner, Bernstein Shur and S. Andrew (Andy) Smith, Baker Newman NoyesOn December 22, 2017, Congress enacted and the President signed the Tax Cuts and Jobs Act that introduced into the Code a tax benefit for certain investments in businesses in Opportunity Zones. Opportunity Zones are distressed communities in each State as designated by the Governor of each State. Since the enactment of the legislation, the Treasury has issued two sets of Proposed Regulations that provide additional guidance regarding these tax benefits. In three separate seminars (one in Portland, one in Bangor, and one in Lewiston) we have presented the basic rules for the tax benefit for an investment in a business in an Opportunity Zone.
The Opportunity Zone tax benefit rules should be viewed as providing two tax benefits: (1) the deferral of taxes on capital gains and (2) the elimination of tax from the appreciation of the investment of capital gains if the investment is held at least 10 years.
A taxpayer may elect to defer the income tax on capital gains from the sale of a capital asset to an unrelated party if the taxpayer invests the capital gains into a qualified opportunity fund within 180 days of the date of the sale. An important special 180-day rule applies to capital gains arising from the sale of a capital asset by a partnership (or LLC that is treated as a partnership for income tax purposes). In this case, if the partnership does not elect to defer the taxes on the capital gain, then the partners (members of the LLC) may elect to defer the taxes on the capital gain during the 180-day period beginning on December 31 of the year of the sale.
The capital gains contributed to the qualified opportunity fund are reduced if the taxpayer retains the investment. If the taxpayer retains the investment in the qualified opportunity fund for 5 years, then the income taxes on 10% of the contributed capital gains are forgiven and if the taxpayer retains the investment in the qualified opportunity fund for 7 years, then the income taxes on an additional 5% of the contributed capital gains are forgiven. The taxpayer must pay income taxes on the remaining capital gains upon the earlier of (a) the date of sale of the investment in the qualified opportunity fund or (b) December 31, 2026.
For example, assume that Taxpayer A sells stock and realizes $100x of capital gain. Within 180 days of the sale of the stock, Taxpayer A transfers the amount of the capital gain to a qualified opportunity fund and elects to defer the income taxes on the capital gain. When Taxpayer A has held his or her investment in the qualified opportunity fund for 5 years, $10x of the capital gains is no longer subject to income tax, and when Taxpayer A has held his or her investment in the qualified opportunity fund for 7 years, another $5x of the capital gains is no longer subject to income tax. If Taxpayer A has held the investment for at least 7 years on December 31, 2026, then Taxpayer A will report $85x of the capital gains on his or her 2026 income tax return.
Also, if the taxpayer holds the investment in the qualified opportunity zone fund for at least 10 years, then any appreciation in value above the initial contribution of capital gains will not be subject to income taxes when the investment is sold. Continuing with our example, if Taxpayer A holds his or her investment in the qualified opportunity fund for 12 years and then sells his or her position in the qualified opportunity fund for $150x, the appreciation of $50x will not be subject to income tax.
The qualified opportunity fund is an important feature of the Opportunity Zone rules. For these purposes, a qualified opportunity fund is an investment vehicle that is organized as a partnership or a corporation. Under the tax rules, a partnership is an unincorporated entity with 2 or more owners. Therefore, a sole member limited liability company that is disregarded for tax purposes is not a partnership and cannot be a qualified opportunity fund. However, a sole member limited liability company that has elected to be treated as a corporation can be a qualified opportunity fund. The purpose of the qualified opportunity fund must be investment in qualified opportunity zone property. The qualified opportunity fund must hold at least 90% of its assets in qualified opportunity zone property, as measured in the middle of each tax year and at the end of each tax year.
The next significant concept is qualified opportunity fund property. For these purposes, qualified opportunity fund property means qualified opportunity zone stock, qualified opportunity zone partnership interest or qualified opportunity zone business property. Qualified opportunity zone stock is stock in a domestic corporation that is purchased for cash by the qualified opportunity zone fund after December 31, 2017, where the corporation is a qualified opportunity zone business (or is a new corporation that is organized to be a qualified opportunity zone business) and during substantially all of the time that the qualified opportunity fund held the stock of the corporation, the corporation was a qualified opportunity zone business. There is a similar definition for a qualified opportunity zone partnership interest. If the qualified opportunity zone fund holds qualified opportunity zone stock or qualified opportunity zone partnership interest, then the qualified opportunity fund holds an ownership interest in the operating business entity.
In addition, the qualified opportunity fund can directly purchase the operating assets of a trade or business, if such assets are qualified opportunity zone business property. Specifically, qualified opportunity zone business property is tangible property (both personal and real estate) that is purchased by the qualified opportunity fund after December 31, 2017, the initial use of the property in the qualified opportunity property commences with the qualified opportunity fund or the qualified opportunity fund significantly improves the property, and during substantially all of the time that the qualified opportunity fund held the property substantially all of the use of such property was in a qualified opportunity zone. A property is significantly improved if expenditures to improve the property during any 30-month period beginning on or after the date of purchase equal or exceed the purchase price of the property.
