A Note From The Legal Helpdesk: A Primer on Opportunity Zones for Alabama REALTORS®
March 18, 2019
Summary
Investments in an Opportunity Zone (OZ) allow an investor to move money from investments in securities, real property, or other financial products into tax advantaged funds dedicated to specific distressed urban and rural communities, which in turn can be used for real estate development. As long as certain requirements are met, investors can carry forward their qualified capital gains in the OZ funds for a number of years and lower their taxable investment income. An investment in an OZ could be compared to how real property acquired in a “like-kind exchange”[i] is treated under the Internal Revenue Code, in that the tax on gains from the new investment or property are deferred.
OZs create an opportunity to redevelop underappreciated and distressed areas around the state with renewed investment opportunities. The hope from the real estate community is that these investments can stimulate economic growth in areas in the same way the Historic Tax Credit and the New Markets Tax Credit have helped spur redevelopment and revitalized downtown areas across Alabama.
Creation Through Recent Tax Reform
Opportunity Zones were established by the Tax Cuts and Jobs Act (“the Act”)[ii] to create incentives for investment in distressed urban and rural communities throughout the United States. Among the main incentives for a person to invest in an OZ are that a taxpayer can 1) defer inclusion of certain capital gains from taxable gross income for corresponding amounts invested in an OZ until 2026, 2) exclude from gross income 10% of the original gains invested in a Qualified Opportunity Fund [more on those below] held for five years before 2026 and 15% of the original gains invested for at least seven years before 2026, and 3) fully exclude appreciation on investment held in the Qualified Opportunity Fund for at least 10 years.[iii] In addition, and most importantly for REALTOR® purposes, real estate development is a way investors can participate in the OZ program.[iv]
Opportunity Zones Designated by State Governors
The OZ provisions established by the Act provide that the chief executive officer of each state, U.S. territory and the District of Columbia designate eligible Low-Income Communities[v] to then be certified by the Internal Revenue Service (IRS) as OZs. 8,761 OZs nationwide were finalized in July 2018.[vi] In Alabama, Governor Kay Ivey worked with the Alabama Department of Economic and Community Affairs (ADECA) to select 158 OZs, with at least one OZ in all 67 counties.[vii] ADECA has published a map of where the Alabama OZs are located, which can be viewed here.
Investing in an Opportunity Zone
To take part in the Opportunity Zone program, eligible taxpayers[viii] establish and/or invest in a Qualified Opportunity Fund (QOF), which is a corporation or partnership set up for investing in an OZ.[ix] To establish a QOF, the QOF submits a self-certification to the IRS in the tax year it is created through a form attached to the QOF’s federal income tax return.[x]
Investments in a QOF must be capital gains (i.e., gains from the sale of a security, real property, or other investment property) invested within 180 days from the date of sale into a QOF.[xi] To qualify for the deductions, investments cannot be made into a QOF by direct cash contribution,[xii] and investments cannot be put directly into activity in an OZ but must go through the QOF.
Duration of Opportunity Zone Program
To be invested in a QOF, a capital gain must be derived from a sale by December 31, 2026, and if made on that date, the investor has until June 29, 2027 to invest the capital gain into the QOF (which would be 180 days from December 31, 2026).[xiii] The amount of tax owed on a capital gain invested in a QOF is reduced depending on how long the investment remains in the QOF, with the reduction starting at an investment held for five years and increasing at seven years.[xiv] In addition, an appreciation in the taxpayer’s QOF investment can be totally excluded from the taxpayer’s federal income tax liability if the investment was held in the QOF for at least 10 years.[xv] Taxpayers can elect to take advantage of the 10-year period on their federal income tax return until December 31, 2047, if their QOF investment was made by June 29, 2027, even though the Opportunity Zone designations will sunset on December 31, 2028.[xvi]
Developing Property in an OZ
REALTORS® will be happy to note that the OZ program encourages development of real property. In particular, under the proposed regulations and an explanatory ruling recently released by the IRS, when a QOF purchases real property in an OZ to improve a building, a QOF is not required to improve the land itself in addition to the building to take advantage of the tax breaks.[xvii] Specifically, the IRS clarified that a QOF is only required to improve the building “at an amount exceeding the value” of the building itself when purchased, rather than having to spend extra money to improve the land also.[xviii]
White House Opportunity and Revitalization Council
On December 12, 2018 President Donald Trump signed an executive order establishing the White House Opportunity and Revitalization Council (“Council”).[xix] The Council is comprised of 13 federal officials and is chaired by Department of Housing and Urban Development (HUD) Secretary Ben Carson.
The Council’s purpose is to engage with all levels of government to find ways to effectively utilize government funding to revitalize low-income areas, especially through coordinating and targeting existing federal programs to Opportunity Zones. The Council will also develop recommendations on changes to federal statutes and regulations to encourage investment in distressed communities, as well as changes to federal statutes and regulations that would assist local governments in utilizing federal resources in distressed communities more effectively.
Conclusion
Opportunity Zones present an exciting opportunity for investors to utilize their capital for supporting at-risk communities. If you are thinking about participating in the Opportunity Zone program, make sure you consult a qualified tax professional or tax attorney before doing so.
Recommended Reading:
“An Unlikely Group of Billionaires and Politicians Has Created the Most Unbelievable Tax Break Ever.” Forbes, July 18, 2018, available here.
“Tax Breaks Open Up ‘Opportunity Zones’ for Investors.” REALTOR® Magazine, October 22, 2018, available here.
[i] See 26 U.S.C. § 1031.
[ii] Pub. L. No. 115-97, 131 Stat. 2054 (2017), codified at 26 U.S.C. § 1400z-1 et seq.
[iii] See 26 U.S.C. § 1400Z-2; see also Preamble to IRS Proposed Regulations Investing in Qualified Opportunity Funds, RIN 1545-BP03, pp.3. On October 19, 2018 the IRS released several publications concerning various parts of the Opportunity Zone program. Among those publications were proposed regulations that, in relevant part, clarify the rules for investments in OZs, which an investor is allowed to rely on before the rules are published in the Federal Register if the investor “applies the rules in their entirety and in a consistent manner.” Preamble to IRS Proposed Regulations Investing in Qualified Opportunity Funds, pp.30. The IRS held a public hearing on the proposed regulations which representatives from the National Association of REALTORS® participated in on February 14, 2019. You can view NAR’s summary of the hearing here.
[iv] 26 U.S.C. § 1400Z-2(d)(2)(D).
[v] An area is eligible for designation as an Opportunity Zone if it meets the requirements of a “low-income community” in 26 U.S.C. § 45D(e), the law governing the New Markets Tax Credit. See § 1400Z–1(c)(1).
[vi] IRS Notice 2018-48; see also IRS Bulletin No. 2018-28, July 9, 2018.
[vii] ADECA Brochure, available at: https://adecagis.alabama.gov/ozoneimages/ozonebrochure.pdf. A map of the state’s Opportunity Zones is available here.
[viii] Under the proposed regulations, eligible taxpayers include individuals, C corporations [including real estate investment trusts (REITS)], partnerships, S corporations, trusts and estates. IRS Proposed Regulations §1.1400Z-2(a)-1(b)(1).
[ix] 26 U.S.C. § 1400Z-2(d)(1).
[x] IRS Proposed Regulations Investing in Qualified Opportunity Funds, §1.1400Z-2(d)-1(a)(1). On October 19, 2018 the IRS published a draft of the new Form 8896 for the QOFs to use to self-certify.
[xi] See 28 U.S.C. § 1400Z-2(a)(1). The explanatory material in the proposed regulations states that an eligible capital gain would be “from an actual, or deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.” Preamble to IRS Proposed Regulations, pp. 6-7.
[xii] Other tax incentives already exist to encourage this type of investment, including the New Markets Tax Credit program and the Historic Tax Credit program.
[xiii] Preamble to IRS Proposed Regulations Investing in Qualified Opportunity Funds, pp. 36; see 28 U.S.C. § 1400Z-2(b)(1)(B).
[xiv] 28 U.S.C. § 1400Z-2(b)(2)(B).
[xv] 28 U.S.C. § 1400Z-2(c).
[xvi] The IRS proposed regulations clarified that, while OZs will terminate in 2028 under current law, investors can realize the tax benefits from their investment in a QOF on their tax return even after OZs are sunsetted. IRS Proposed Regulations Investing in Qualified Opportunity Funds, §1.1400Z-2(c)-1(b); see also 28 U.S.C. §1400Z–1(f).
[xvii] IRS Revenue Ruling 2018-29; IRS Proposed Regulations §1.1400Z-2(d)-1(c)(8)(ii) (clarifying 28 U.S.C. § 1400Z-2(d)(2)(D)(i)).
[xviii] IRS Proposed Regulations Investing in Qualified Opportunity Funds, §1.1400Z-2(d)-1(c)(8)(i); see also Rev. Rul. 2018-29. The improvements to the building must take place within 30 months of the acquisition of the building. Id.
[xix] Executive Order No. 13,853 (2018).
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