By: Zac Johnston
In 2017, Congress passed the Tax Cuts and Jobs Act creating the opportunity scheme to spur economic development in distressed communities.[1] First, an individual or corporation is able to defer capital gains tax by investing any long-term capital gain in an opportunity zone within 180 days of the gain.[2] Second, the basis in the opportunity zone, which should be zero[3], increases at five years to 10% of the investment and increases again at seven years to 15%.[4] Therefore, it effectively allows up to 15% of tax free capital gains, after deferring the original capital gain tax.[5] Third, if the investment in the opportunity zone is held for ten years, then the investor has the ability to receive the gain on the investment in the opportunity zone tax free.[6] In a wrinkle to this scheme, the tax code calls for an assumed sale of opportunity zone investments in 2026.[7] The assumed sale creates two major issues for investors: investment deadlines and phantom income.[8]
In order to be eligible for the 15% increase in basis of capital gains invested in an opportunity zones, the investment must take place in 2019 to meet the seven-year requirement.[9] Simillary, the investment must be made by 2021 in order to meet the five-year requirement for the 10% increase.[10] While theses deadlines do not seem like an issue for investors, the lack of guidance on the technical aspects of opportunity zones are scaring off investors.[11] Currently, there are proposed regulations out for comment, mainly focusing on the techinical reguirements of what type of investments qualify as opportunity zone investments.[12] The IRS planned to hold a call to discuss some of the requirements for an investment to qualify as an opportunity zone investment; however, that call was postponed indefinitely due to the government shut down.[13] If the government does not have adequate regulations by the end of 2019 investors will have to make a decision between two options. Making the investment in 2019 to be eligible get the 15% basis increase before the assumed sale or two wait to be sure they are taking the right steps and miss out on the additional 5% for investing for seven years as opposed to only hitting the five year mark.[14]
Additionally, the requirement of an assumed sale of an opportunity zone investment in 2026 at its fair market value will create phantom income for investors.[15] Investors will be required to pay tax on their original capital gain, with a possible basis adjustment of 10% or 15% provided in the code.[16] Additionally, the appreciation on the value of their investment in the opportunity zone will tax as a capital gain.[17] The phantom income in 2026 will have a very real impact on the investors tax return in 2026[18], which must include the defered capital gain and any capital gain from teh appreciation of the opportunity zone investment. It is possible that Investors might feel the need to sell their investments in the opportunity zone, taking advantage of any basis increase they can, in order to pay their tax. Additionally, this assumed sale will provide a forced evaluation of their investment. After the 2026 assumed sale, the only benefit to an investor will be if they hold their investment for the ten-year time frame, allowing them to have a tax free appreciation from the 2026 assumed sale date.[19] It is possible investors will reevaluate their expected return from the opportunity zone investment in comparison to the expected rate of return in other investments. The tax free appreciation after the ten-year statutory period will be an element they consider, but with a capital gains tax rate at 15%, 10% or 0% depending on the investors tax bracket, a low rate will only provide a marginal benefit for investors to stay in the opportunity zone investment.[20]
The issues described above provide challenges to investors who are interested in investing in opportunity zones, or just interested in the tax incentives. However, the other side of the coin of opportunity zones are the communities they are supposed to help. With the confusion surrounding the technical aspects of what qualifies as an opportunity zone, and the lack of guidance from the administration, the investments in opportunity zones are slow coming. If opportunity zones are going to create the impact that is excepted in these communities, the guidance should be fast tracked in order to make the impact seen quickly.
[1] IRS, Opportunity Zones Frequently Asked Question, IRS (Jan. 11, 2019), https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions.
[2] 26 USCS § 1400Z-2(a)(1)(A).
[3] 26 USCS § 1012.
[4] 26 USCS § 1400Z-2(b)(2)(B)(iii)-(iv).
[5] See 26 USCS § 1400Z-2(a)(1)(A); 26 USCS § 1011.
[6] 26 USCS § 1400Z-2(c).
[7] 26 USCS § 1400Z-2(b)(1)(B).
[8] 26 USCS § 1400Z-2(b)(1)(B) (creating a date that the investment will be treated as income without a sale occuring and a investment deadline in order to reach the five or seven year holding requirement).
[9] 26 USCS § 1400Z-2(b)(1)(B).
[10] 26 USCS § 1400Z-2(b)(1)(B).
[11] Joshua Pollard, IRS: Welcome Back, Opportunity Zones Need Your Attention, Forbes (Jan. 28, 2019, 9:36 AM), https://www.forbes.com/sites/joshuapollard/2019/01/28/irs-welcome-back-opportunity-zones-need-your-attention/#7322e08874e1.
[12] Id.
[13] Id.
[14] 26 USCS § 1400Z-2(b)(2)(B)(iii)-(iv)(seven years before 2026 is 2019 and five years before 2026 is 2021).
[15] See 26 USCS § 1400Z-2(b)(2)(B); 26 USCS § 61(a)(3).
[16] 26 USCS § 1400Z-2(b)(2)(B).
[17] 26 USCS § 1222.
[18] 26 USCS § 1400Z-2(b)(1)(B)(creating a taxable event that will be required to be reported on the 2026 tax return of the investor).
[19] 26 USCS § 1400Z-2(c).
[20] 26 USCS § 1400Z-2(h).
