Much ink has been devoted in recent years to the widening income gap in our country, but as we noted in our January blog, “Rural Development Council Works to Keep Georgia On Your Mind,” geographic disparities since the Great Recession have hit rural and low-income communities in Georgia particularly hard. In yet another proactive move to address this problem, the state has positioned itself to take advantage of the new Qualified Opportunity Zone (QOZ) program under the recent Tax Cuts and Jobs Act.
The QOZ program is structured to promote development in economically distressed communities by providing tax incentives for investors to divert their investment gains – tax-deferred – into funds (a qualified Opportunity Fund) that invest in businesses and property development within a QOZ. Additional tax incentives are available the longer the Opportunity Fund investment is held.
Last week, Gov. Nathan Deal announced that the U.S. Department of the Treasury and the Internal Revenue Service (IRS) have approved 260 zones from approximately 80 counties throughout the State of Georgia as Qualified Opportunity Zones, comprising 60 percent rural communities and 40 percent urban communities. Fulton County, Muscogee County, Bibb County, Richmond County, DeKalb County, and Dougherty County are home to the largest numbers of designated QOZs, with 27, 16, 15, 13, 12, and 10 zones, respectively.
The new tax law permits the chief executive of each state and the District of Columbia to nominate “low-income communities” eligible for or communities “contiguous” to designated low-income communities, subject to certain statutory limitations. Low-income communities are generally defined as population census tracts in which the poverty rate is at least 20 percent or with median family incomes that do not exceed 80 percent of area median income (different measurements are permitted depending on whether the tract is within or outside of a metropolitan area). The list of all QOZs designated to date, including those in Georgia, can be viewed here. The QOZ designation will be good for 10 years, allowing longer-term investors to reap significant tax incentives under the QOZ program.
Tax Incentives of QOZ Program
Investors in the stock market have done particularly well since the recession. The S&P 500 nearly tripled between 2009 and 2016, and the Dow Jones Industrial Average rose more than 140 percent between 2009 and 2017. Investors are sitting on significant unrealized capital gains that could go a long way toward jump-starting communities given enough incentive to attract the first investor or developer into a distressed area, which becomes a tipping point for additional investment. (This is the “first-mover” problem identified by the Economic Innovation Group on page 14 of this report).
Under the QOZ program, an investor can defer capital gains tax on realized gains if the gains are invested in a qualified Opportunity Fund within 180 days of the sale. The tax deferral ends, and a recognition date occurs, upon the earlier of the date the investor sells its Opportunity Fund investment or December 31, 2026. In either case, on that recognition date, the amount of recognized gain is equal to the excess of (a) the lesser of the amount of deferred gain or the fair market value of the investment at sale, over (b) the taxpayer’s basis in the Opportunity Fund.
Initially, the tax basis is deemed to be zero. If the Opportunity Fund investment is held for at least 5 years, the basis is increased to 10 percent of the deferred gain, and if the Opportunity Fund investment is held for at least 7 years, the basis is increased to 15 percent of the deferred gain. If the Opportunity Fund investment is held past December 31, 2026, the investor will be deemed to realize the deferred capital gains as of December 31, 2026 and will pay capital gains tax on the amount of recognized gains as of that date (determined as described above, with basis adjustments if applicable). The basis is then adjusted to equal the amount of the original Opportunity Fund investment. Finally, if the investor holds the Opportunity Fund investment for at least 10 years, the basis is deemed to be the fair market value of the Opportunity Fund investment and no capital gains tax will apply to the appreciation on the Opportunity Fund investment. Some examples are provided below; actual tax obligations may vary based on the taxpayer’s individual circumstances.
Example A: No Opportunity Fund Investment
- Investor A has $1,000,000 in unrealized capital gains on stock.
- If Investor A sells the stock on May 1, 2018 without electing to invest in an Opportunity Fund, he will realize $1,000,000 in capital gains and pay applicable capital gains tax on all $1,000,000 in his 2018 tax return.
Example B: 10 percent – 15 percent Basis Step-Up
- Investor B has $1,000,000 in unrealized capital gains on stock.
- Investor B sells the stock on May 1, 2018, and invests the $1,000,000 in an Opportunity Fund on July 1, 2018. She elects the capital gains deferral each year while she holds the Opportunity Fund investment.
- If she sells the Opportunity Fund investment in 2024 (more than 5 years) at a fair market value of $1,500,000, her basis in the deferred gain is $100,000. Investor B will pay capital gains tax on $900,000.
- If she sells the Opportunity Fund investment in 2026 (more than 7 years) at a fair market value of $1,600,000, her basis in the deferred gain is $150,000. Investor B will pay capital gains tax on $850,000.
Example C: Basis Increases to Fair Market Value
- Investor C has $1,000,000 in unrealized capital gains on stock.
- Investor C sells the stock on May 1, 2018, and invests the $1,000,000 in an Opportunity Fund within 180 days. She elects the capital gains deferral each year while she holds the Opportunity Fund investment.
- On December 31, 2026, Investor C is deemed to have a basis in the deferred gain of $150,000. She will pay capital gains tax on $850,000.
- Her basis in the Opportunity Fund investment then increases to $1,000,000.
- If Investor C sells her Opportunity Fund investment for a fair market value of $1,800,000 in 2027, she will pay capital gains tax on the $800,000 appreciation. If she holds her investment for at least 10 years (e.g., sells after 2028) and makes the applicable special election, her basis will be equal to the full fair market value at the time of the sale and she will pay no recognized capital gains tax on the Opportunity Fund investment appreciation.
Additional Detail on What Qualifies as an Opportunity Fund and QOZ Property
A qualified Opportunity Fund is any investment vehicle (a) organized as a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone Property (QOZ Property) other than another Opportunity Fund and (b) holds at least 90 percent of its assets in QOZ Property, determined by the average of the percentage of QOZ Property held on the end of the first six months of the taxable year and on the last day of the taxable year. Opportunity Funds must be certified by the U.S. Treasury Department.
An Opportunity Fund may be subject to monthly penalties if it fails to meet the 90 percent unless the Opportunity Fund can show that the failure was due to reasonable cause. Banks, financial institutions – including community development financial institutions (CDFIs, certified by the CDFI Fund of the U.S. Treasury Department) – and community development entities (CDEs, certified by the CDFI Fund as part of the existing New Markets Tax Credit (NMTC) program), and high net worth individuals are likely candidates for organizing an Opportunity Fund and soliciting investor funds.
QOZ Property comprises (a) stock or partnership interests acquired, solely in exchange for cash, after December 31, 2017 in a business that is, or is being organized for the purpose of being, a QOZ Business, and/or (b) QOZ Business Property. A QOZ Business is, generally, a trade or business in which substantially all of the tangible property owned or leased by the taxpayer is QOZ Business Property, at least 50 percent of income is derived from the active conduct of such business, a substantial portion of the intangible property of the business is used in the active conduct of such business, and less than 5 percent of unadjusted basis of property is attributable to nonqualified financial property
QOZ Business Property generally is tangible property, acquired after December 31, 2017 and used in a trade or business of the Opportunity Fund if the original use of the property in the QOZ commences with the Opportunity Fund, or the Opportunity Fund substantially improves the property, and substantially all of the use of such property is in an Opportunity Fund during substantially all of the holding period for such property. Local entrepreneurs (perhaps in coordination with universities or startup incubators), developers and high-growth companies are likely candidates to establish QOZ Businesses or to improve QOZ Business Property.
Certain other rules apply, such as a provision for property that ceases to be QOZ Business Property, and investments in funds that hold both QOZ Business Property and non-qualified business property. Further, ‘sin’ businesses (e.g., private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetrack or gambling facilities, or liquor stores) are specifically excluded from eligibility as a QOZ Business.
QOZ Program Guidance
The U.S. Treasury Department still needs to provide guidance on the process it (or perhaps the CDFI Fund) will follow to certify Opportunity Funds – and issue regulations to guide the QOZ program – before interested investors, funds, developers, and QOZs can fully implement the program. According to the CDFI Fund website, the authority to implement program regulations has been delegated to the IRS, which welcomes comments on what the regulations for certification of Opportunity Funds and eligible investments should include.
Parties with experience in the NMTC program are particularly well suited to help shape the final regulations for the QOZ program. The program is similar in some ways to, but is distinct from, the existing NMTC program. Under the QOZ program, tax credits were deliberately excluded in order to emphasize private investment over public sector financing. The NMTC program generally subsidizes loans to qualified businesses in low-income communities, whereas the QOZ program emphasizes equity investments and the tax deferrals cannot be applied to loans. Finally, there is no volume limit to the amount of equity that may be used in the QOZ program. The QOZ and NMTC programs may be used to complement each other in a single development project.
The Qualified Opportunity Zone program has the potential to induce measurable investments in designated low-income communities. This is an exciting new tool for designated rural and distressed communities throughout the State of Georgia that also provides a meaningful tax benefit to investors and another business opportunity for financial intermediaries.