Maryland has taken the lead in a group of states removing barriers preventing socially conscious investors from connecting with nonprofit organizations and underserved communities.
A new statute passed as part of the Tax Cuts and Jobs Act of 2017 seeks to encourage investment in disadvantaged communities nationwide by providing individuals, partnerships, and corporations significant capital gains tax benefits when re-invested in certain underserved communities, called Opportunity Zones.
The statute authorizes corporations and partnerships to form and start community projects benefitting designated Opportunity Zones. The projects then connect with investors who reinvest capital gains in the corporation or partnership, receiving potentially significant tax benefits in the process.
While regulators are still working on details of the statute’s implementation nationwide, several states, including Maryland, are working quickly to facilitate investment in their Opportunity Zones. It is important to ensure that an investment into an Opportunity Zone complies with all applicable requirements in order to realize the tax benefits offered by the Opportunity Zone program.
Internal Revenue Code Section 1400Z, enacted by the Tax Cuts and Jobs Act of 2017 (the “Act”), provides for the deferral of taxable gain from the sale of property if the gain is reinvested in an Opportunity Zone Fund (a “Fund”) within 180 days after the sale.
What are opportunity zones funds?
Determining whether an investment vehicle qualifies as a Fund requires ensuring that several sets of requirements are met at each level of the business. Limited liability companies, corporations, and partnerships can all qualify as Funds as long as they meet the requirements. The Act defines a Fund as any investment vehicle that is organized for the purposes of investing in “qualified opportunity zone property” and that holds at least 90% of its assets in “qualified opportunity zone property.” A Fund that fails to meet the 90%-threshold must pay a monthly penalty for each month in which it fails to meet the threshold. Guidance issued by the IRS in March 2019 has clarified that that a Fund has at least six months from the time the Fund raises a round of capital to when they need to place that capital for the purposes of the 90% test.
“Qualified opportunity zone property” means any of the following: stock or partnership interests in a domestic corporation or domestic partnership acquired for cash after December 31, 2017, or qualified opportunity zone business property. In order for the stock or partnership interests to qualify as qualified opportunity zone property, the applicable corporation or partnership must be considered a qualified opportunity zone business at the time of the investment and for the entire holding period of the interest. Qualified opportunity zone business property is tangible property that was acquired by purchase after December 31, 2017, either originally used concurrently with the Fund or substantially improved by the Fund, and substantially all of which was used in the Opportunity Zone during substantially all of the Fund’s holding period.
In order to substantially improve tangible property, during any 30-month period beginning after the date of acquisition of the property, the Fund must spend as much to improve the property (measured by additions to basis) as the Fund’s original basis in the property at the beginning of the 30-month period. In March 2019, the IRS issued additional guidance on what constitutes “original use” with respect to the qualified opportunity zone business property analysis. Properties that have been vacant for at least five years qualify for original use investment. However, land must have a business use to qualify, so land held for investment that does not give rise to a trade or business does not qualify as qualified opportunity zone business property. Existing property can qualify for original use as long as the property was not previously used in such a way that would have allowed it to be previously depreciated or amortized by any taxpayer.
A “qualified opportunity zone business” is a trade or business in which substantially all of the taxpayer’s property is qualified opportunity zone business property (discussed above). There are also several additional requirements for a trade or business to qualify as a “qualified opportunity zone business,” including a requirement that 50% of the business’s gross income be derived from the active conduct of such trade or business in an Opportunity Zone, that a substantial portion of intangible property is used in the active conduct of such trade or business in the Opportunity Zone, that less than 5% of the average of the aggregated unadjusted bases of such entity’s property is attributable to “nonqualified financial property”, and that the entity’s business is not used for private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, gambling facilities (including race tracks), or liquor stores.
What are the benefits of investing in opportunity zone funds?
There are three potential tax benefits to investing in a Fund: (1) temporary deferral of reinvested gains, (2) a partial step-up in basis, and (3) a permanent exclusion from federal income tax.
Temporary Deferral. When investors sell appreciated assets and reinvest the gains in qualified Opportunity Funds, like tax-free exchanges under Internal Revenue Code Section 1031, they may temporarily defer recognition of the initial capital gain from sale to the earlier of the date on which the Opportunity Fund investment is disposed or December 31, 2026. The deferred capital gain is included in the taxpayer’s gross income on the earlier of the date on which the investment is sold or exchanged or December 31, 2026.
The amount of gain included in the gross income on the date in which it was realized is equal to the amount that either the deferred capital gain or the fair market value of the taxpayer’s investment (whichever is less) exceeds the taxpayer’s basis in the Fund.
Step-Up in Basis. While a taxpayer’s basis in the Fund is generally deemed to be zero, depending on the length of the investment, the basis of such investment can be increased. If the investment is held for at least five years, the basis of such investment is increased by an amount equal to ten percent of the deferred capital gain. If the investment is held for seven years, the basis in the investment is increased by an additional five percent of the deferred capital gain. If the investment has not been sold by December 31, 2026, the remaining 85% of deferred capital gain must be recognized and the basis of the investment is increased to 100% of the deferred capital gain.
Permanent Exclusion. If the investment is held for at least ten years, a second election may be made to increase the basis of the investment to the fair market value of the investment on the date it is sold or exchanged. This means that any gain on the investment in excess of the amount of any deferred capital gain recognized on December 31, 2026 is excluded from gross income. However, because December 31, 2026 will occur before any qualified investment has been held for ten years, deferred capital gain is never fully included from income. A taxpayer can make this election as late as December 31, 2047, even after the Opportunity Zone designation has expired.
IRS guidelines issued in March 2019 have clarified that if a fund has to sell a business or property before the ten-year exit, the fund has a one-year grace period in which to sell assets and reinvest the proceeds. Individuals will not be taxed for any fund-level activity as long as they do not take any distributions. Tax benefits will be tied to an investor’s duration in the fund, not the duration of the fund.
Maryland Opportunity Zones Information Exchange
So far, the only type of opportunity zone investment straightforward enough for investors to feel safe despite the unsettled regulations is for a Qualified Opportunity Fund that invests in a single real estate property, according to Maryland Department of Housing & Community Development Director of Strategic Business Initiatives Frank Dickson
To attract early investment in its Opportunity Zones, the Maryland Department of Housing and Community Development recently developed a first-of-its-kind Information Exchange. Taxpayers can search the Information Exchange to find available businesses, funds or projects in Maryland in which they can invest.
Because the Opportunity Zone program is relatively new, the IRS has periodically issued, and is likely to continue issuing, clarifying guidance as to how the program works. In light of this changing landscape, it is especially important to consult with qualified legal and accounting professionals to ensure that the Fund meets all necessary requirements to reap the benefits of investing in a Fund.
Lauren Ades is a Member with PK Law and Chairs the firm’s Corporate and Real Estate Group. She has significant experience in the areas of corporate and business law, commercial financing and real estate. She advises clients in mergers and acquisitions, business formation and business and real estate transactions that range from the relatively simple to highly complex. Ms. Ades can be reached at firstname.lastname@example.org or (410) 339-6742.
Diva Bole is an associate in PK Law’s Corporate and Real Estate Group. She focuses her practice area on business formation, mergers and acquisitions, joint ventures, commercial lending, financing and leasing, complex contracts, and corporate restructuring. Ms. Bole can be reaced at email@example.com or (410) 938-2645.