Opportunity zones represent the first new tax incentive for private capital in low-income communities since the creation of the new markets tax credit (NMTC) in 2000.
A little-noticed section in the $1.5 trillion tax cut that President Trump signed into law late last month is drawing attention from venture capitalists, state government officials and mayors across America. The provision, on Page 130 of the tax overhaul, creates “Opportunity Zones,” which will use tax incentives to draw long-term investment to parts of America that continue to struggle with high poverty and sluggish job and business growth. The provision is the first new substantial federal attempt to aid those communities in more than a decade.
Opportunity Zones are low-income census tracts eligible to use tax incentives to encourage long-term investments in Zone assets and property. As of December 2017 and within 120 days, Opportunity Zones can be designated as such by the governor or chief executive of a given state, district, or territory. All 50 states, the District of Columbia, and U.S. territories are eligible to designate Opportunity Zones.
Generally speaking, a census tract will be eligible for designation as a Qualified Opportunity Zone if it has a poverty rate of at least 20% or a median income that does not exceed 80% of the metropolitan median income or the statewide median income. Certain census tracts that are contiguous to tracts meeting those income requirements are also eligible for Qualified Opportunity Zone designation. A maximum of 25 percent of a state or territories’ low-income census tracts may be designated as Opportunity Zones. If a given state or territory has less than 100 low-income census tracts, it may still designate 25 state Opportunity Zones.
This program creates a new potential source of capital for businesses and real estate developments located in Qualified Opportunity Zones, while at the same time creating a new tax benefit for investors seeking to reduce their tax burden on taxable asset dispositions.
Tax Benefits to Investing in Opportunity Zones
Investing capital gains in Opportunity Zones can result in either a temporary deferral of the capital gains tax, or a permanent exclusion depending on the amount of time those investments are held in a Zone. Investments are eligible for deferment after a 5 year period, and they are eligible for permanent exclusion if held for at least 10 years.
More than $2 trillion in unrealized capital gains are sitting on individual and corporate balance sheets across America, according to the Economic Innovation Group, the result of profitable investments in stocks and mutual funds. Normally, the proceeds from the sale of those assets would be taxed as a capital gain, at a maximum federal rate of 20 percent plus a 3.8 percent surtax. The new law offers investors an alternative: to roll those unrealized gains into an Opportunity Fund, and defer federal taxes on the profit, at least temporarily.
That deferral grows into capital gains tax relief the longer the investment is held. An investor who retains an investment for seven years will pay only 85 percent of the capital gains taxes that would have been due on the original investment. If the investment is held beyond 10 years, the investor permanently avoids capital gains taxes on any proceeds from the Opportunity Fund investment.
What are Opportunity Funds?
Opportunity Funds are Treasury-certified investment vehicles that deploy capital into Opportunity Zones. Opportunity Funds are required to hold at least 90 percent of their assets in an Opportunity Zone, or face penalty for each month it fails to meet the investment requirement. The penalty equals the amount of the investment shortfall, multiplied by the underpayment rate as defined in Section 6621(a)(2) of the Internal Revenue Code.
It’s still unclear how many states will participate in the program, and how open the process will be to decide which low-income census tracts will get a designation. As we wait for the process to unfold, please contact McGuire Sponel to keep you informed on your State and what areas have been designated census tracts.