On Friday, the Treasury Department released new regulations on the Opportunity Zones program—an investment tool established by 2017’s TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Cuts and Jobs Act—that will allow investors to defer and eliminate capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. es on gains from investments in economically-distressed localities.
The new rules provide some clarity on how investors can qualify for the tax break, but there are still plenty of unanswered questions and potential issues that could arise during implementation.
Between April and June of this year, the zones were designated by the Treasury Department based on census tract recommendations from the governors of all 50 states and many U.S. territories. The result: roughly 9,000 zones encompassing 35 million Americans.
When investing in opportunity zones, investors must roll unrealized capital gains from an outside investment into opportunity funds, the investment vehicles for the zones. Opportunity funds attract investors with three generous benefits related to capital gains taxation:
- Capital gains tax on the rolled over investment is deferred until 2026 or upon withdrawal from the fund.
- Capital gains tax on the rolled over investment can be reduced by up to 15 percent after seven years in an opportunity fund via a step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair market. This eliminates the capital gain that occurred between the original purchase of the asset and the heir’s acquisition, reducing the heir’s tax liability. .
- If the investment is held for at least 10 years, any new gains derived from the opportunity fund are permanently excluded from capital gains taxation.
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The new regulations cover some of the questions that investors had about the program and ask for input on further issues.
The original legislation dictates that an opportunity fund is required to have 90 percent of its assets in qualified opportunity zone property, and that the qualified opportunity zone business must have “substantially all” of its tangible property within an opportunity zone. The proposed regulations dictate the definition of “substantially all” as 70 percent.
Combining the 90 percent asset requirement for opportunity funds with the 70 percent tangible property requirement for qualifying businesses means that an opportunity fund may be as minimally invested in a zone as 63 percent.
Additionally, the proposed regulations clear up an ambiguity in the law about what happens if a census tract loses its opportunity zone designation after 10 years. If a taxpayer kept money in a zone that later loses its designation as an opportunity zone, would the taxpayer lose out on the full tax benefit? Alternatively, could investors hold assets in a fund indefinitely and receive the tax break at any point in the future?
As a compromise, the proposed regulations state that investors can keep their investments in funds through 2047 without losing any of the tax benefits, even if the zone loses its eligibility in the interim. This rule will likely be updated in the future and is simply to clarify that 10 years likely will not be a hard cut-off for benefits—meaning that investors don’t have to rush into investments right away—but that the tax preference would not last forever.
The proposed regulations also clarify that gains can be transferred from opportunity fund to opportunity fund until 2026 (at which point the deferred and reduced capital gains tax must be paid). More regulations on fund to fund transferring are still to come.
Many businesses which work with investments that take longer to get off the ground due to construction projects (like real-estate developers) were concerned about the 180-day time limit to roll over gains into an opportunity fund. The businesses feared being penalized for funds accumulated while still completing their investments. The U.S. Treasury Department proposed a 30-month extension for businesses in this situation to hold working capital, so long as they have plans for a qualified project that may be auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. ed by the Internal Revenue Service.
Treasury also said to expect more regulations by the end of the year on the treatment of business operations, because some business functions can occur outside of opportunity zones. For example, the treatment of a delivery truck operated by a qualified business inside a zone.
All in all, these regulations will do very little to fix the major problem with opportunity zones, which is their inherent lack of neutrality. Sound tax policy does not limit or distort investment by type or location. The benefits given to investors through opportunity funds are remarkably generous, and many of these regulations only increase and widen those benefits without regard to the results.Share