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Qualified Opportunity Zones: Invest Now or Wait for IRS Guidance?

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The 2017 Tax Cuts & Jobs Act created a new measure that was meant to encourage investment in certain low-income areas, or "Opportunity Zones," through various tax incentives. While enticing on the surface, the measure is full of restrictions and language that is unclear at best. Not as many investors have taken advantage of the program as anticipated, and one of the reasons could be the need for further clarification from the IRS.

Opportunity Zones Do Have Benefits...

Whether it's a single investment or an opportunity zone (OZ) fund that pools investor resources, the idea of these funds is to reduce risk even though they're putting money into so-called "risky" locales. The main attraction is the triple tax break.

First, if you have money that you've earned from another investment (capital gains), you can defer the taxes on those gains by investing them into an OZ within 180 days. Second, the longer you hold onto your OZ investment, the more you'll reduce the amount of capital gains that will be subject to taxes. For example, five years means a 10% reduction, and you get another 5% reduction at seven years. Finally, hold that investment for 10 years and your gains become tax-free.

...But There are Trade-Offs

Unfortunately, not everyone is eligible to invest in an OZ, and many investors have found them downright confusing. For example, any OZ fund must invest 90% of its assets into businesses located within the opportunity zone.

An OZ is able to either self-certify to the IRS or join a qualified fund that is offered by an investment manager. There are currently more than 8,700 Qualified OZs in the U.S. and its territories.

The IRS has had to clarify several issues with regards to the Qualified Opportunity Zone program.

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And the Tax Questions Make Them Risky

One of the things that makes OZ investments risky are the myriad questions still surrounding the verbiage in the measure. If you misread something or make some other error, you could be subject to IRS penalties and find that you are ineligible for the tax incentives that you were targeting.

Indeed, the IRS has already released two additional sets of program regulations meant to clarify how OZs work. The first set of guidance, released in Oct. 2018, addressed only the business aspects of the program. The second set, released in April 2019, seeks to clarify many issues relative to the tax breaks.

That second guidance is still at the proposal level, so the rules haven't been finalized yet. Some of the things that the new regulations will seek to answer include:

  • Treatment of Sec. 1231 gain - Clarification of the treatment of net Sec. 1231 gains for reinvestment in an OZ since the netting process doesn't take place until the end of the year.
  • Trade-or-business standard - Clarify the definition of a "trade or business" with reference to a qualified OZ.
  • Definition of "substantially all" - The measure uses this term repeatedly, so a definition would be helpful.
  • Leased property - More clarification is needed relative to how certain leases are treated within a qualified OZ.
  • Valuation methods - Clarity on the different valuation methods available to meet the 90% asset requirement.
  • Carried interests - Clarification of whether carried interest can qualify to obtain the benefits of this program.
  • Inclusion events - Lists the events that qualify for the taxpayer to begin paying on the original deferred gain.

Whether investors are jumping into opportunity zones now or waiting for even more guidance from the IRS is unclear. However, additional clarification is on the way. For the most part, the ones the that are getting the most benefits are investors that were going to do the deals anyway instead of entrepreneurs that are "fashioning" deals in these zones that might also come with lock-up periods and high fees.