The Tax Cuts and Jobs Act includes a new program called Opportunity Zones (each, an “OZ”) that offers significant tax incentives for investors to help to attract funding for projects and businesses in low-income areas.
Under the incentive, individuals and other entities can delay paying federal income tax on capital gains until as late as December 31, 2026 if those gains are invested in “Opportunity Funds” that invest at least 90% of their assets in businesses or tangible property located in low-income areas designated as OZs. Further, the gains on investments in the Opportunity Funds can be federal income tax-free if the investment is held for at least 10 years. The tax benefits could reduce the cost of capital for these projects, making them more viable, especially when paired with other development incentives like the New Markets Tax Credit. Congress intended that the OZ incentive operate with minimal restrictions in order to maximize investor participation and thus economic activity and job creation. The K&L Gates OZ Team provides a full spectrum of cross-practice services to help fund sponsors, developers, innovators, and investors understand and implement this new incentive in order to unlock its full investment potential.
Because the OZ incentive was included in legislation that advanced through Congress quickly, certain details and contours of the incentive continue to be defined by the U.S. Department of the Treasury (“Treasury”), the Internal Revenue Service (“IRS”), other federal regulatory agencies, and the Congress. Because of the complexity and evolving nature of the OZ rules, it is critical that those interested in the OZ incentive seek counsel early in the process to avoid making irrevocable decisions that could prevent receipt of OZ benefits.
We Have the Team to Help
K&L Gates offers a full suite of practice areas necessary to understand and implement the OZ program. We understand that operating in this space requires a cross-practice, multifaceted approach to navigating the logistical, legal, and regulatory hurdles that may arise. Our multi-disciplined team of tax, tax policy, investment management, real estate, renewable energy, and tax-exempt organizations/nonprofit institutions professionals collaborate to advise and provide full-service guidance to educate clients about the incentive, evaluate whether the incentive is consistent with client goals, address legal and regulatory hurdles, and help execute engagement in the incentive. These services include developing fund products to meet client needs and objectives; providing advice regarding the significant regulatory considerations related to organizing and operating Opportunity Funds; securities law compliance, including registering the fund sponsor as an investment adviser or qualifying for an exemption; complying with tax obligations for investments in Opportunity Funds; and determining and meeting the eligibility requirements for qualified OZ properties or OZ businesses. We help clients to fully understand, manage, and mitigate these and other issues. To help clients stay abreast of current developments, members of our OZ team frequently host presentations and speaking engagements, author articles, and are regularly quoted in the media on OZ-related issues, including commentary that has appeared in Law360 and Tax Notes.
Who Should Consider Participating in the OZ Incentive?
Anyone interested in unlocking investment potential in low-income communities should learn more about the OZ incentive, including parties who can organize the funds and parties with money to invest. Fund sponsors, real estate developers, innovators, businesses with underserved community initiatives, cities, urban and rural economic development associations, family offices, foreign investors with U.S. capital gains, and institutional and private investors all should consider the opportunities of the program.
The Nuts and Bolts of the OZ Incentive
What are OZs?
OZs are population census tracts analogous to low-income communities qualifying for the New Markets Tax Credit. OZs have been selected by the Governors of all 50 states and U.S. territories.
What is an Opportunity Fund?
A qualified Opportunity Fund is any investment vehicle organized as a corporation or a partnership (including limited liability companies taxed as partnerships) for the purpose of investing in and holding at least 90% of its assets in qualified OZ property. The Opportunity Fund may invest in multiple OZs. Any business or individual (including non-U.S. persons) with taxable capital gains arising from the sale or exchange with an unrelated person of any business or nonbusiness property, including stock, real estate, or personal property, may invest the capital gains in the Opportunity Fund within 180 days of the transaction and enjoy tax deferral on the gains. Special rules apply to capital gains realized through fiscally transparent entities. Taxes on the capital gains are deferred until the earlier of the disposition of the investment in the Opportunity Fund or December 31, 2026, with 10% and 5% increases in basis at the five- and seven-year marks, respectively (a total of up to 15%). Gains on Opportunity Fund investments (but not the deferred capital gains) held for at least 10 years will not be subject to federal income tax.
What is Qualified OZ Property?
Qualified OZ property generally includes any qualified OZ stock, any qualified OZ partnership interest, and any qualified OZ business property acquired after December 31, 2017. As discussed further below, qualified stocks and qualified partnership interests must be in corporations and partnerships (including limited liability companies taxed as partnerships) that are qualified OZ businesses. Qualified OZ business property is tangible property used in a business of the qualified Opportunity Fund where the original use begins with the Opportunity Fund or the Opportunity Fund substantially improves the property (with certain exclusions).
What is a Qualified OZ Business?
A qualified OZ business is an active trade or business, consistent with the policy of the program to stimulate economic activity and create jobs, Substantially all of the tangible property used in the business must be qualified OZ business property. At least 50% of the total gross income of the business must be from the active conduct of the business, a substantial portion of the entity’s intangible property must be used in the active conduct of the business, and less than 5% of a fund’s aggregate unadjusted bases in assets may be in unqualified financial property, including debt, options, and certain other financial products. Certain types of businesses, including golf courses, racetracks, gaming facilities, and establishments selling alcohol for off-premise use, do not qualify.