Many members of the opportunity zone community can remember where they were on Nov. 15, 2017, when the Senate Finance Committee added qualified opportunity zones to the bill that became Public Law 115-97 (the law formerly known as the Tax Cuts and Jobs Act of 2017 or TCJA).
Over the past three years, qualified opportunity funds have apparently raised $75 billion, which have poured into designated low-income communities and certain adjacent census tracts across the country.
While some opportunity funds involve real estate projects, other opportunity funds have focused on operating businesses such as alternative energy, life sciences and other tech startups, professional services, locally grown salads and more distant agricultural producers, and cannabis businesses from coast to Colorado to coast.
The opportunity zone community’s end of 2020 is not as exciting as the end of last year, when many Christmas, Hanukkah, and Kwanzaa celebrations were interrupted by the release of 544 pages of final opportunity zone regulations (see Libin Zhang, Opportunity Zones: Final Regulations and Outlook for 2020, Daily Tax Report (Dec. 30, 2019), 61 Tax Management Memorandum 2 (Jan. 20, 2020), 36 Tax Management Real Estate Journal No. 2 (Feb. 19, 2020)). Nevertheless, the Covid-19 pandemic and the results of the 2020 presidential election may affect the future of opportunity zones and opportunity zone people of color (OZPOC) in 2021 and beyond.
Capital Gains and Time Travel Paradoxes
The opportunity zone federal tax benefits are:
1. Most types of capital gains can be deferred until the end of 2026 by investing in an opportunity fund, which can be as simple as a two-member limited liability company.
2. The deferred gains are reduced by 10% (or 15%) or more if the opportunity fund interest is held for five years (or seven years) before the gains are recognized. (The 15% reduction instead of 10% effectively became unavailable after the end of 2019, after which new investors lose out on that 1% economic benefit.)
3. After a gain-deferring taxpayer holds the opportunity fund interest for at least 10 years, the taxpayer generally does not recognize any taxable gain on exit through the end of 2047.
Although the tax statute technically requires capital gains to be invested in an opportunity fund within a 180 day period starting when the gain is recognized, the more flexible final regulations allow some gains to be invested as late as mid-September of the following calendar year. As relief from the Covid-19 pandemic, Notice 2020-39 further extended most 2020 investment deadlines to Dec. 31, 2020.
For example, an individual taxpayer has $1 million of long-term capital gains, $1 million of short-term capital gains, and $1 million of long-term capital losses allocated from hedge funds in 2019. Without an opportunity fund investment, she would recognize $1 million of short-term capital gains in 2019 subject to federal ordinary income tax rates of up to 40.8%.
The taxpayer can make a $1 million investment in an opportunity fund on Dec. 1, 2020 and elect to defer $1 million of 2019 long-term capital gains to potentially 2026. The $1 million of long-term capital losses offset the remaining $1 million of short-term capital gains to result in zero 2019 tax. The taxpayer effectively converts 2019 short-term capital gains into 2026 long-term capital gains.
A temporal distortion is introduced by the fact that the 2019 personal income tax return is still due on Oct. 15, 2020. One option is to first pay full 2019 tax on the capital gains and then file an amended 2019 return after Dec. 1 to claim a refund for the deferred $1 million of capital gains. Other options can involve less tax payment upfront.
The $1 million of 2019 long-term capital gains are generally deferred until the end of 2026, at which point up to 90% of the deferred long-term capital gains are subject to U.S. federal income tax at 2026 tax rates. Joseph Biden would like to increase the federal long-term capital gain tax rate from 23.8% to 43.4%. A tax increase might apply retroactively starting on Jan. 1, 2021. A historical analogy is when Bill Clinton signed the Revenue Reconciliation Act of 1993 into law on Aug. 10, 1993, which increased the highest ordinary income tax rate from 31% to 39.6% (plus an expanded 2.9% Medicare tax) as of Jan. 1, 1993.
Some commentators claim that it could still make economic sense to defer 2020 capital gains to 2026 even when future capital gains tax rates are nearly doubled. Investors should check the modeling assumptions and maybe compare it against a deferral of any capital gains realized in 2021. For taxpayers who have already invested in an opportunity fund over the past three years, they can structure ways to recognize the previously deferred gains in late 2020 while still preserving some or most of the taxpayer’s ability for a tax-free exit after 10 years.
The Senate can pass tax legislation with only 50 or 51 votes under reconciliation procedures. Higher taxes are less likely if the Democratic Party has only 48 or 49 Senate seats. If the Democrats do take control of the Senate after Georgia’s two Senate run-off elections on Jan. 5, 2021, taxpayers in early 2021 can recognize taxable gains back in 2020 and avoid 2020 gain deferrals by using certain retroactive tax elections.
The year 2026 occurs after the 2024 presidential election, which may result in a new presidential administration and lower tax rates. Alternatively, tax rates may increase further in anticipation of tens of billions of dollars of deferred gains recognized in 2026.
Diversity and Inclusion
During the third Trump-Biden presidential debate on Oct. 22, 2020, Trump noted that the opportunity zone program was “one of the most successful programs” and that “tremendous investment is being made. Biggest beneficiary: the Black and Hispanic communities and then historically Black colleges and universities.” But some commentators have observed that opportunity fund investments might not fully benefit the OZPOC community.
The Biden Plan to Build Back Better by Advancing Racial Equity Across the American Economy states that “Biden initially hoped that Opportunity Zones would be structured and administered by the Trump Administration in a way that advanced racial equity, small business creation, and homeownership in low-income urban, rural, and tribal communities. It is now clear that the Trump Administration has failed to deliver on that promise in too many places around America.”
The focus on diversity, inclusion, equity, and social impact may increase in the coming years. It is expected that few opportunity zone tax practitioners are opposed to diversity and inclusion efforts. Given that the opportunity zone program was a new creation that everyone has to learn from the beginning in 2017, and its important racial equity considerations, law and accounting firms have had an excellent opportunity for many of their diverse attorneys and tax specialists to build up the firms’ opportunity zone practices over the past three years.
Diversity and inclusion should be particularly important for opportunity funds and their advisers who are active in the country’s culturally diverse areas, such as Florida, California, Texas, and much of the rest of the southern U.S..
The scope of any opportunity zone reform is unclear, nor is it clear whether existing opportunity zone projects will be grandfathered. Biden may take some pages from the opportunity zone reform bills of Senator Ron Wyden (D-OR) or Representative Jim Clyburn (D-SC) and retroactively prevent opportunity funds from owning golf courses, country clubs, casinos, massage parlors, tanning salons, hot tub facilities, and liquor stores, which currently can be owned by opportunity funds with proper advice and structuring (see Treas. Reg. 1.1400Z2(d)-2(d)(4)(iv) Ex. 3 (golf course owned by an opportunity fund)). The bills would generally also add new tax reporting requirements and retroactively expand the above excluded businesses (or “sin businesses”) to discourage opportunity fund investments in parking garages, self-storage property, sports stadiums, tennis clubs, racquetball courts, skating rinks, health club facilities, airplanes, and any residential rental property that contains less than half low-income housing.
State-level reform efforts can provide precedent. Washington, D.C. enacted the well-known Fiscal Year 2021 Emergency Budget Support Act (D.C. Act 23-404) in August 2020. Opportunity zone benefits are allowed for D.C. tax purposes (including the 8.25% D.C. unincorporated business tax) only if the opportunity fund is specifically certified by D.C.’s mayor as meeting various conditions, including that it makes certain types of investments in solely D.C. opportunity zones. The law does not explicitly grandfather existing projects. The federal government and other states may be similarly inspired to channel opportunity zone dollars to favored causes.
Opportunity zones are census tracts designated by the state governor in 2018 after up to four months of study and deliberations by stakeholders. One question is what happens after the 2020 census, which can merge smaller census tracts, divide larger census tracts with growing populations, and adjust the boundaries of others. Although the general expectation is that opportunity zone boundaries are fixed for the next thirty years, the issue of census tract changes is mentioned in the Treasury and IRS 2020-2021 Priority Guidance Plan.
Opportunity Fund Qualifications
An opportunity fund’s lower-tier subsidiary must generally meet all the requirements to be a “qualified opportunity zone business” (QOZB). A QOZB must have at least 70% of its tangible assets generally consist of qualified tangible property that is located in an opportunity zone, is acquired by purchase from an unrelated party in 2018 or later, and meets various other requirements. Based on the fact that cash is an intangible asset, the regulations explicitly provide that cash is not qualifying tangible property for any purpose; a QOZB that owns only cash and contributed land (i.e., not acquired by purchase) or land acquired before 2018 would not numerically satisfy the 70% tangible property test when it applies to the QOZB.
Some opportunity funds have taken the position that the 70% tangible property test does not apply at all during a QOZB’s first few years, which means that potentially a QOZB can own exclusively nonqualifying property during that entire time. Given the paramount importance of maintaining opportunity fund status over 10 or more years in order to not jeopardize each investor’s tax-free exit, a well-reasoned legal analysis from reputable counsel may be appropriate for some uncertain tax issues.
Loss of QOZB status will have adverse consequences in many later years. Notice 2020-39 waives any penalties if an opportunity fund fails its tax requirements in 2020, but an opportunity fund may have problems in 2021 and later if a lower-tier subsidiary fails to be a QOZB in 2020. An opportunity fund can sometimes be better off revoking its opportunity fund status to avoid continuing monthly penalties, based on the decertification procedures issued by the IRS on Nov. 4, 2020.
A “working capital safe harbor” generally requires a QOZB to spend all of its cash over a period of 31 months. As relief from the Covid-19 pandemic, Notice 2020-39 generally provides that if a QOZB has cash covered by the working capital safe harbor as of 2020 year end, the business receives “not more than an additional 24 months” to expend the cash as long as all the other safe harbor requirements are met. The relief has some ambiguities, including that the 24 month extension might not be automatically available for everyone.
A QOZB has a 50% gross income test that can be met by generally having at least 50% of its employees and independent contractors work in opportunity zones, measured by either compensation or service hours. The Covid-19 pandemic has caused more people to work from homes that are not necessarily in opportunity zones. Opportunity funds can consider creative ways to encourage their highest paid or hardest working employees and independent contractors, including their tax advisors and legal counsel, to move to opportunity zones.
The opportunity zone program’s flexibility has attracted much attention over the past three years. When opportunity zone advisers are structuring opportunity zone investments, they cannot have only an understanding of the tax rules about opportunity zones, partnerships, passive activity losses, REITs, corporations, consolidated groups, LIHTC, other tax credits, FIRPTA, tax code Section 1202 small business stock, and state and local income taxes. Firms and practitioners should also be aware of diversity and inclusion concerns and other BIPOC and OZPOC issues that can affect opportunity funds for the next 10 or 30 years. When 2020 is compared to 2010, a society can change a lot in a decade.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Libin Zhang is a tax partner at Fried, Frank, Harris, Shriver & Jacobson LLP in the New York office. His mid-2018 research on hot tubs and other opportunity zone hot topics was cited in U.S. Senate Committee on the Budget, Tax Expenditures: Compendium of Background Materials on Individual Provisions, 115th Cong. 2d Sess., S. Print 115-28, at 601 (Dec. 2018).