Article

2019 year-end tax letter: opportunity zone considerations

Authored by Michael Wronsky and Colin Walsh

The “opportunity zones” program remains one of the -- if not the -- most compelling provisions of the Tax Cuts and Jobs Act (TCJA). The program provides taxpayers with certain tax deferral and exclusion benefits in exchange for investing capital gains in low-income communities designated as qualified opportunity zones (QOZ) via an investment vehicle called a qualified opportunity fund (QOF). For additional background and details regarding opportunity zones, please see our most recent Tax Alerts from April and June of 2019.

While the program’s tax incentives offer opportunities for both tax deferral and some permanent exclusion from taxation, the language of the governing statutes created significant compliance-related uncertainties that resulted in barriers to entry. Since the TCJA’s enactment, two rounds of proposed regulations issued in October 2018 and April 2019 clarified many of these issues, allowing potential participants and their advisors to proceed with greater confidence, although more regulatory guidance is pending.

Investors may ask if all this complexity is right for them. Would an old-fashioned section 1031 like-kind exchange make more sense? This article focuses on just some of the many key investment safeguards investors should consider and offers a comparison of the OZ program with like-kind exchanges for reference.

Key takeaway: Taxpayers expecting material gains should carefully consider the complexities of investing in a QOZ as part of the transaction planning.

Investment safeguards. Before investing in any QOF, we recommend investors review the associated legal documents, operating agreements, etc., for the following:

  • A provision in the operating agreement that the manager will operate the QOF in a manner that the QOF will not be subject to penalty under IRC section 1400Z-2(f)
  • Whether the agreement restricts the manager from disposing of QOZ property before a significant number of investors are eligible to make the 10-year election since failure to meet the holding requirement would negate tax benefits of the investment
  • A provision prohibiting the entity from taking on any capital investments prior to certification to a QOF; if capital is contributed prior to certification, it is not eligible for the tax deferral and exclusion benefits
  • A stipulation that if an “inclusion event” occurs to accelerate gain and that event is not a sales transaction, the agreement should require the QOF to determine the fair market value of its investments, as the gain recognition is limited to fair market value

    (We recommend against investing gain realized by an S corporation into a QOF. Future changes in excess of 25% in the ownership of the S corporation can result in an acceleration of the gain. Instead, the individual shareholders of the S corporation should consider the OZ investment on their own rather than via the S corporation to eliminate this potential trap.)
  • Restrictions on the manager’s ability to make debt-financed distributions; specifically, distributions should not be made within two years of a refinance or made to an investor within two years of their investment in the QOF

Comparing OZ (IRC 1400Z) with like-kind exchanges (IRC 1031)

With the enactment of opportunity zones, investors now have two potential options for gain deferral, including the like-kind exchange program, which has been around for decades.

Here’s a quick comparison of the two:

Comparing OZ (IRC 1400Z) with like-kind exchanges (IRC 1031)

Finally, it should be noted that IRC section 1202 may also create significant tax savings, if applicable. More specifically, it permits noncorporate shareholders to exclude 100% of the gain realized on so-called qualified small business stock (QSBS). Several requirements must be satisfied to qualify as QSBS, but section 1202 should be evaluated in conjunction with what’s above.

Conclusion

Investing in a QOZ is complex and considering the risks and benefits should be part of your tax planning when you expect to realize a material gain.

Looking forward, Treasury officials recently announced that the two issuances of proposed regulations will be consolidated into a single round of final regulations, which they are hopeful will be “by the end of the year.” At this time, we do not know how the finalized guidance will differ from the proposed regulations, but expect our analysis of their contents upon release.

For more, visit our opportunity zone page.

View more insights in the 2019 year-end tax planning letter >

Download the 2019 year-end tax planning letter >

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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