CW Industrial Partners


The Private Equity for Families Blog

Opportunity Zones- Gimmick or Gamechanger?  

A little-known provision of the Trump Tax Reform Act of 2017 was bipartisan support for an interesting tax incentive around investments in Opportunity Zones. This is the hottest tax dodge since tax shelters in the 1980’s, but whether it will serve its purpose of distressed community development is uncertain.

Here are a few Q&A clarifications from a recent IRS publication explaining how the tax regimen will work:

Q – What is an Opportunity Zone?

A – 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 via his delegation of authority to the Internal Revenue Service. Click here to search your geography (the box to type the address into is up in the top right corner).  You will need to have or download flash for the link to work correctly.  

Q – How do Opportunity Zones spur economic development?

A – Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026.   If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.  If held for more than 7 years, the 10% becomes 15%.  Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that investment is realized (emphasis added)

Q- I sold some stock for a gain in 2018, and, during the 180-day period beginning on the date of the sale, I invested the amount of the gain in a Qualified Opportunity Fund.  Can I defer paying tax on that gain?

A – Yes, you may elect to defer the tax on the amount of the gain invested in a Qualified Opportunity Fund. Therefore, if you only invest part of your gain in a Qualified Opportunity Fund(s), you can elect to defer tax on only the part of the gain which was invested.

What Does This Mean For Qualified Opportunity Zones?

Interestingly, investments in real estate as well as businesses located in those designated communities could qualify for tax deferral on the source of the investment capital as well as tax forgiveness on the gain from the new investment. The applicability to real estate development is clear, but the rules for business investment are quite tricky.

Let’s take the example of an apartment development in Tremont, a trendy neighborhood just south of Cleveland, Ohio. A developer owns a property which he has permitted for a 5 Floor Apartment Building with construction planned for 2019. His project construction costs are $7.5 million of which $2.0 million is equity. The developer forms an Ohio limited partnership “QOF Fund I, LP.” to invest in the Tremont apartment building project and, possibly, a follow-on project across the street.

Luckily, the developer has a relationship with the Gotrocks family who just sold their family business in early 2019 for a substantial gain. The developer suggests the Gotrocks invest $1.0 million in QOF Fund I. He then makes the same proposal to several other families with a similar capital gains and cash to invest. They pool their resources and fund all $2.0 million of equity. Non-rollover investors can participate in the investment but they will not get any of the tax benefits.

Gotrocks family has a good accounting firm, Counter, Beans and Sheets. They advise Gotrocks to claim a deferral of $1.0 mil of the large gain from the sale of the family business on their 2018 1040 tax return even though that event was late 2018 and the QOF investment was early in 2019. Counter Beans explains that any capital gain is eligible for deferral if the QOF investment is made within 180 days after the date of sale (for pass through entities it is year end regardless of transaction date).

Counter Beans also explains to Gotrocks that the $1.0 million deferral is until 2026 (or earlier if the replacement project is realized) and, if the apartment investment is held for 5 years Gotrocks can also exclude 10% of the $1.0 million family business gain and 15% if they hold the apartment project for 7 years (2026)!

The Real Tax Benefit

That is just the icing on the cake. Gotrocks can also exclude 100% of its share of the gain on the sale of the apartment building project if it is held for 10 years (2029). Not surprisingly, it looks like the developer (think Trump Enterprises) can also exclude 100% of his gain from a carried interest even though he would have made only a nominal capital investment.

Counter Beans says IRS is still developing rules on whether debt is included in tax basis for purposes of calculating gain on the sale of the projects. There should also be clarification about the tax treatment for promoters.

What About Small Businesses?

The rules are more complicated. For a business investment to qualify its revenues and income must be “principally” generated within the boundaries of the Opportunity Zone. According to recent IRS clarifications, “Principally” means 70% of 90% or 63%. So, if a yoga studio had three locations inside the Zone and one outside the Zone and each had similar revenue, the QOF could invest in all four and, if those 4 studios were held for 10 years,  still write up the QOF tax basis in all four to fair market upon realization in a sale transaction.

Many Unanswered Questions

There are still interesting questions. If a QOF project or a business distributes capital gain profits before selling in year 11, do those profits qualify for a tax refund? How can a high growth business with sales mostly outside the Opportunity Zone qualify? Will this tax break really stimulate community redevelopment?

This tax change has stimulated a significant buzz at holiday gatherings, especially because many investors have taken gains in the stock market. While the motivation is tax savings, it may turn out that some good community redevelopment work also takes place?

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records. Founder and chairman of CW Industrial Partners (originally CapitalWorks, LLC), he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CW Industrial Partners or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.