The Opportunity Zones program was established by Congress in the Tax Cut and Jobs Act as an innovative approach to spurring long-term private sector investments in low-income urban and rural communities nationwide. The program is based on the bipartisan Investing in Opportunity Act.

WHAT IS AN OPPORTUNITY ZONE?

An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury.

1. Opportunity Zones were added to the tax code by the Tax Cuts and Jobs Act on December 22, 2017.
2. Opportunity Zones are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities.
3. Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains until the earlier of the date on which an investment is sold or exchanged, or December 31, 2026, so long as the gain is reinvested in a Qualified Opportunity Fund. Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor would be eligible for an increase in basis equal to the fair market value of the investment on the date that the investment is sold or exchanged.

SO, WHAT’S THE BIG HYPE?

The program establishes a mechanism that enables investors with capital gains tax liabilities across the country to receive favorable tax treatment for investing in Opportunity Funds that are certified by the U.S. Treasury Department. The Opportunity Funds use the capital invested to make equity investments in businesses and real estate in Opportunity Zones designated by each state.

Investors who plow a 2018 capital gain into an opportunity fund gets three breaks:

1. Deferral of tax on their 2018 gain until 2016
2. A 15% reduction on those gains when they are taxed in 2026
3. Tax free growth of their opportunity investment, as long as they hold it for at least ten years.

INVESTOR INVESTMENT EXAMPLE:

In 2018, an individual investor sells 1,000 shares of Amazon stock that they purchased in 2013 for $250,000. The sale at $1,250 per share results in a $1 million capital gain. Instead of paying the $238,000 (assuming 20% rate and 3.8% net invest income tax) in federal capital gains tax on this sale, the investor rolls their $1 million gain into a Qualified Opportunity Fund that invests the capital in newly issued preferred stock shares of various operating businesses located in Opportunity Zones with a plan to liquidate the fund in 2028.

The assumed value of this investment in 2028 is $2 million. The benefits received by this investor include:

1. Must be certified by the U.S. Treasury Department.
2. Must be organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property.

3. Must hold at least 90% of their assets in Qualified Opportunity Zone Property.

4.Qualified Opportunity Zone property includes newly issued stock, partnership interests, or business property in a Qualified Opportunity Zone business.

5.Opportunity Fund investments are limited to equity investments in businesses, real estate, and business assets that are located in a Qualified Opportunity Zone. Loans are not eligible for the tax incentives. Opportunity Fund investments in real estate are subject to a substantial rehabilitation requirement.

EXAMPLES OF POTENTIAL OPPORTUNITY FUNDS

1. A $100 million national private equity fund that provides growth capital to lower middle market operating businesses located in Opportunity Zones.
2. A $10 million local fund that provides the equity capital for the $100 million redevelopment of a closed shopping mall into a mixed-use development that includes new neighborhood retail and workforce housing.
3. A $20 million disaster area fund that develops and leases new affordable housing for residents displaced by the 2017 hurricanes and forest fires.

However, there are at least three strategies that allow a qualified opportunity fund to be open to its entire community, including non-accredited investors:

1. Real estate fund: A fund whose primary business is investing in real estate and 90% of whose assets consist of real estate in an opportunity zone will be a qualified opportunity fund and will be exempt from the burdensome regulations of the Investment Company Act of 1940 (the “1940 Act”), which paves the way for the fund to raise capital via a direct public offering – making it a true community investment fund.

2. Small business holding company: This type of fund is exempt from the 1940 Act if most of its assets comprise controlled or majority-owned subsidiaries – the idea being that the fund is in whatever business its subsidiaries are in, rather than in the securities investment business. Again, if 90% of its holdings are businesses in opportunity zones, it will also be a qualified opportunity fund.

3. Intrastate fund: A closed-end fund of up to $10 million, all of whose investors reside in the same state, is eligible to seek an exemptive order from the SEC that allows it to raise community capital via a direct public offering and while avoiding all or most of the 1940 Act’s regulations. Such a fund could invest in either business or real estate in opportunity zones and thereby also become a qualified opportunity fund.

With any of these strategies, a community-scale fund can open up the opportunity for community ownership of community assets, with everyone able to participate on a level playing field, and everyone able to reap the profits from local ventures.

Over the next few months, the Treasury Department and the Internal Revenue Service will be providing further details, including additional legal guidance, on this new incentive. More information will be available at Treasury.gov and IRS.gov.