The Qualified Opportunity Zone provision — Code Section 1400Z — was slipped into the Tax Cuts and Jobs Act late in the legislative process and with very little fanfare, but has quickly gained a foothold in the lexicon of investment advisors. And there are good reasons for that: By investing in a qualified opportunity fund, taxpayers can defer, and to some extent wipe out, tax on capital gains.
But for investors who want to take full advantage of the benefits, time is running out. In order to qualify for the maximum 15 percent amount of forgiveness offered under the Tax Code, the investment must be held for seven years before the end of 2026. That leaves just two months to make the investment before the end of 2019. However, if the Dec. 31, 2019, deadline is missed, there is still the opportunity to obtain 10 percent forgiveness on investments held for at least five years by the end of 2026. And if the investment is held for 10 or more years, any appreciation is tax-free.
In case that’s confusing, the 15 percent or 10 percent forgiveness after seven years or five years, respectively, applies to the gain on the sale of assets put into the fund; the entire exclusion from tax applies to any appreciation after it’s put into the fund, explained Mark Luscombe, a CPA and principal federal tax analyst at Wolters Kluwer Tax & Accounting.
“Most observers view [the 10-year entire exclusion of tax on the appreciation of assets placed into the fund] as the most important benefit, rather than the loss of 5 percent,” he said. “Complete forgiveness of gain while in the fund could be the real benefit.”
“Some of the promoters are making a big deal about the upcoming deadline,” Luscombe said. “But there has been some reluctance by investors to jump in because of unanswered questions. And for real estate, there is still the option for a Section 1031 exchange, which has more clearly established rules at this point.“
Troy Merkel, partner and Opportunity Zone group leader at Top 5 Firm RSM US, agreed.
“While investments made after Dec. 31, 2019, will not be eligible for the full 15 percent reduction of the original capital gain, this fact is having a minimal impact on investor behavior,” he said. “Any investment made after then would still be eligible for the 10 percent reduction of the original capital gain. The difference between the 15 percent and 10 percent reduction doesn’t have a significant impact on most investments.”
Although the deadline is not pressing investors into bad investments, there is some pressure generated by the requirement on investors to deploy capital within 180 days of the sale of the asset giving rise to the gain, Merkel indicated. “This pressure to deploy the capital in a relatively short period of time can cause investors to rush into investments that might be riskier,” he said.
“Adding pressure can sometimes beget risk,” Merkel observed. “With capital gains coming out of the roller coaster ride that the market has been on for the past six months, investors have capital gains that they are under pressure to deploy.”
There are two sets of proposed regulations, Merkel indicated. “They were supposed to issue final regs in October 2019, but that looks unlikely now. However, they have made it clear that we can rely on the majority of what was issued last October and in April of this year.”
Rather than simply finalizing the proposed regulations, the final regs are likely to address some new issues, according to Luscombe. “There might be some new guidance, because people are still raising questions on the proposed regs,” he said. “There have been additional people who have commented on the proposed regulations, so I would expect the IRS to address these in the final guidance.”
And there are a few pieces left open in the proposed regs, Merkel observed. “These have to do with calculating the penalties if an Opportunity Zone business is noncompliant with program parameters, and also with the reporting on the program’s impact in driving job growth and economic growth in Opportunity Zones. Those are the two most significant areas that need to be clarified.”
While precise numbers aren’t available, the program hasn’t quite met its initial expectations, Merkel noted: “No one can dispute that it has yet to live up to its hype, but the level of hype was so substantial that it was unreal to think that it would,” he said. “That being said, the program has driven development in Opportunity Zones, and we’re starting to see investments that will drive job growth as private equity funds and social impact funds take advantage of the program.”
