Opportunity Fund Zones: Three Ticking Clocks?

Posted on by Kurt Magette in Commercial Real Estate, Corporate and Business, Tax

On November 7, 2018, I published a blog entitled: Opportunity Zones: Tax Deferral and Exclusion Beyond Like-Kind Exchanges”. Since then, the Treasury Department has issued over 500 pages of Final Regulations and other guidance. This area is nuanced, ambiguous, and unkind to any foot faults. However, given the right economic project, the rewards deserve study.

This blog is not a 20 or more-page tax treatise, which even then, would only scratch the surface of the exceptions, caveats, and assumptions. It is intended to outline the basic rules with typical assumptions and to encourage Persons (such as corporations, tax partnerships, and individuals) with significant capital gains to talk to their tax advisors.

Assume that all parties are on a calendar tax year and a tax partnership (typically an LLC) has two equal Members (C and D) and has $2 million capital gain in 2021. The LLC had a $600,000 tax basis on its property sold, and each of the Members had a $300,000 tax basis in his LLC Interest just before the sale.

Although the LLC, itself, could have reinvested in a Qualified Opportunity Zone Fund (“OZ Fund”), assume it did not (C wanted his cash out), so the LLC liquidated and distributed $1,300,000 to each Member (NB: the aggregate liquidation proceeds are $2.6 million with capital gain of $2 million-plus $600,000 in basis recovery.)

D wants to explore deferral. He must invest in an OZ Fund within a designated 180-day period: not before and not after. Furthermore, the OZ Fund must have qualified and elected to be an OZ Fund on or before D’s investment. D has three choices:

1) He can have his 180-day period be identical to the LLC. Assume the LLC sale was on 11/15/21, this 180-day period began on, and included 11/15/21). Obviously, this choice has no utility.

2) He can have his 180-day period begin on, and include 12/31/21.

3) He can have his 180-day period begin on, and include 3/15/22. This last choice is intriguing and should give D the ability to do due diligence on an OZ Fund and make the investment on or before 9/10/22. If D’s cash investment in the OZ Fund were $1 million and if he made the proper election with his 2021 tax return, he could defer that gain even though it is 2021 gain. Also, notice that he can keep his $300,000 in cash from basis recovery (unlike a like-kind exchange. Please see my previous blog).

However, the clock is ticking. This investment will probably be in a multi-tiered real estate development in an area, which Virginia designated and the US certified, as an Opportunity Zone. Although that creates special risk, Virginia has 212 of these zones. Just in the Richmond area, many parts of Scott’s Addition, Manchester, and Church Hill qualify. Confirming qualification requires a simple web search. If D is self-developing, he needs sterling advice. If he is investing in a managed fund, due diligence on the developer is paramount.

D should not make a bad economic investment chasing tax deferral. However, his federal and Virginia income tax deferral from his $1 million investment could be about $250,000 to over $300,000 plus interest if D is late on his estimated payments.

All this initial deferral must be recognized on 12/31/26 if it has not been recognized through an “inclusion event” before. Inclusion events include D’s sale of his interest in the OZ Fund, the OZ Fund’s sale of the project, or numerous other incidents that constitute D’s disinvestment. Thus, another clock is ticking. D has a decent remaining period for initial deferral (11/15/21 to 12/31/26), but the time value wanes for others with, say, 2022 gain. D will face the tax rates existing on 12/31/26 on his $1 million initial deferral. However, notice that this inclusion will only be on the initial deferral. D’s investment could have increased to, for example, a $1.6 million value, but only the initial $1 million must be recognized on 12/31/26.

For the extremely long-term investor, if the investment in the OZ Fund is held for 10 years or more, upon election, the investor gets full exclusion of the gain when he sells it. Assume that D sells his investment in the OZ Fund on December 2, 2028, for $2 million. D receives the entire $2 million without any federal or Virginia income tax. In the alternative, assume that D waits an additional two years and sells the investment for $4 million. He receives the entire $4 million without any federal or Virginia income tax. Thus, a third clock is ticking, but this ticking is good for D. If he can hold for 10 years or more, he reaches tax nirvana (at least as close as possible with a Virginia investment).

This discussion is based on current federal tax law and current Virginia conformity. Many US Congressmen have questioned the value of the program with the insinuation that it only benefits real estate owners and developers. Avoiding the politics and confessing that I am not an economist, do you believe that a rising tide raises all ships? These provisions have created incentives for capital investment in Qualified Opportunity Zones, which was the provisions’ mission. Although these provisions apply to investment in zone businesses, the bias towards real estate may be a function of: (i) the relative newness of working regulations (real estate must be developed before businesses can move into the zone), (ii) most businesses have substantial risk of not surviving 10 or more years, much less being sold rather than shuttered (see, any pandemic restaurant); and (iii) real estate is inherently long-term.

Perhaps, the criticizing Congressmen should tweak the rules and not scrap them. The program currently only applies to capital gain that are realized before 2027. Without action, the rules will scrap themselves. Perhaps, four clocks are ticking.

About the Author

Kurt Magette is a business, commercial real estate, and tax lawyer. His practice focuses on business and commercial real estate transactions requiring significant expertise in federal and Virginia income taxes.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.