The recently enacted Tax Cuts and Jobs Act provided for a new set of provisions designed to incentivize long-term investment in certain low-income areas nominated by states and designated by the Treasury Department (Opportunity Zones, currently listed here). These new provisions have generated significant excitement and buzz from impact investors and traditional investors alike, but some of this excitement was hampered by ongoing uncertainty about the details of the provisions. On October 19, the Treasury Department and Internal Revenue Service (IRS) issued proposed regulations relating to these provisions, providing some much-needed clarity on a handful of key points, including on points where the lack of clarity and flexibility had dissuaded some taxpayers from taking advantage of the benefits on offer.
Opportunity Zones?
The provisions regarding Opportunity Zones (contained in Section 1400Z-2 of the Internal Revenue Code) have created more excitement than other, similar programs in the past because, unlike investments governed by those, investments in Opportunity Zone Funds (pooled investment entities that invest in qualifying business and property within Opportunity Zones and are qualified with the IRS) allow for not one, not two, but three valuable tax benefits.
An individual or entity that sells an asset and recognizes capital gains on the sale of that asset (like upon a sale of stock or real estate), if they choose to reinvest those capital gains in an Opportunity Zone Fund, gets to (1) defer that original gain for up to 8 years, (2) if they have held their interest in the Opportunity Zone Fund for specified periods of time, exclude up to 15% of that original gain, and (3) if they have held the interest in the Opportunity Zone Fund for at least 10 years, entirely exclude any gain from the sale of that interest in the Opportunity Zone Fund. Taken together, these create powerful incentives to divest from current investments and make long-term investments in low-income areas, which many are hopeful will drive changes that lead to new jobs and improvements in the quality of life of the residents of these low-income communities.
Some Much-Needed Clarity
The proposed regulations provide clarity on a number of issues left murky by the original Internal Revenue Code provisions themselves. Many of the highlights of these changes revolve around clarifying the various tests that qualify an Opportunity Zone Fund as such. An Opportunity Zone Fund is any partnership or corporation organized for the purpose of investing in certain qualified opportunity zone property and at least 90% of the assets of which consist of this opportunity zone property (commonly referred to as the 90% test). Qualified Opportunity Zone property includes both tangible property that meets certain qualifications and equity interests in businesses in Opportunity Zones that meet certain qualifications (an Opportunity Zone Business). One of these is the requirement that "substantially all" of the business's tangible property meets the same qualifications as property held directly by an Opportunity Zone Fund. The new regulations provide clarity both for funds evaluating qualifying investments and for businesses hoping to attract investments from Opportunity Zone Funds, by clarifying that an Opportunity Zone Business meets the requirement that "substantially all" of its assets consist of qualified Opportunity Zone business property so long as 70% of its tangible property so qualifies, and that Opportunity Zone Businesses can retain cash and certain debt as reasonable working capital while still meeting the qualifications. The proposed regulations also provide specific guidance on the methodology to be used in calculating compliance with the 90% test for Opportunity Zone Funds themselves.
Looking Ahead
These changes provide funds and small business owners in low-income areas much needed clarity. While a number of funds have already launched plans for Opportunity Zone Funds, particularly in the real estate space, the issuance of the proposed regulations is hoped to spur even further action. While some issues and unanswered questions still remain, even after the issuance of the proposed regulations, investors and nonprofits interested in the space are working to develop insights about the way the provisions will work as they unfold and contribute to shaping the space in a way that will help optimize the potential benefits of this investment in low-income communities.
If you are still curious, you can find MoFo's deeper dive into Opportunity Zone Funds and the proposed regulations here.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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