The Opportunity Zone program, created by the Tax Cuts and Jobs Act of 2017, provides investors with a powerful tax incentive to make long-term investments in state-designated economically distressed communities. The U.S. Treasury Department has certified approximately 9,000 Qualified Opportunity Zones (QOZs) in urban and rural areas across the country. Investors with capital gains can defer and, in some cases, exclude those gains from income by reinvesting them into an opportunity zone.
What are the potential benefits for community banks? It’s unlikely that many banks will invest directly in opportunity zone projects, but some are creating funds to make equity investments in these projects. But perhaps the most significant benefit for community banks is the opportunity to make loans in connection with development projects that might otherwise not be economically feasible — absent the tax breaks available in opportunity zones. And these loans may also help a bank meet Community Reinvestment Act requirements.
THE WAY IT WORKS
It’s important to recognize that, to enjoy the tax benefits offered by the program, investors can’t simply write a check to the developer of a project in a QOZ. First, the investor must show recognized capital gains from other investments. Second, the investor must reinvest those gains, within 180 days, in a Qualified Opportunity Fund (QOF), which is a corporation or partnership formed for the purpose of investing in QOZs. Note that special rules apply to capital gains allocated from partnerships and other pass-through entities to their owners. Under those circumstances, investors should consult their tax advisors to determine when the 180-day period starts. Virtually any individual or organization can create and manage a QOF, with a single investor or many investors. To qualify, at least 90% of the fund’s assets must be “QOZ property.” This includes tangible property that’s used by a trade or business within a QOZ and meets specific other requirements (QOZ business property). It also includes equity interests in qualifying corporations or partnerships (QOZ businesses), if substantially all of their tangible property is QOZ business property. The tax benefits for investors in QOFs are attractive. First, the tax on reinvested capital gains is deferred until the end of 2026 or the date the QOF investment is disposed of, whichever comes first. Next, investors enjoy a 10% reduction in the amount of taxable capital gain if they hold the QOF investment for at least five years — and 15% if they hold the investment for at least seven years. Finally, investors who hold their QOF investments for at least 10 years avoid capital gains tax on the appreciation of the QOF investment itself.
Consider this example: On September 1, 2019, Bill sells his interest in stock, generating $2 million in capital gain. Bill establishes a single-investor QOF for the purpose of acquiring and developing commercial real estate in a QOZ valued at $10 million. On December 1, Bill reinvests his entire $2 million gain into the QOF, which borrows the remaining $8 million needed to acquire the property from a community bank. Bill holds the QOF investment until December 15, 2029. At the end of 2026, Bill has satisfied the seven-year holding period, so he’s taxed on only 85%, or $1.7 million, of the original $2 million gain. Now, suppose that the value of Bill’s interest in the QOF has grown to $7 million by the time he disposes of it on December 15, 2029. Because he’s met the 10-year holding period, the entire $5 million in appreciation is tax-free.
TIMING IS EVERYTHING
If your bank is exploring ways to take advantage of the Opportunity Zone program, you should start as soon as possible. That’s because investors who wish to maximize the available tax benefits must invest in a QOF by the end of this year. Otherwise, they can’t meet the seven-year holding period that’s required for a 15% gain reduction by year-end 2026. Of course, investors can still enjoy a 10% gain reduction, which requires a five-year holding period. A requirement: They must invest by the end of 2021. At press time, the IRS was continuing to fine-tune a complex set of proposed regulations on the QOZ program. So be sure to consult your tax advisors before getting involved in QOZ projects.