Investing in qualified opportunity zones in Puerto Rico.

Date01 May 2023
AuthorWallwork, Adam

Investors seeking to minimize their recognition of capital gains are likely aware of the qualified opportunity zone (QOZ) provisions enacted as part of the law known as the Tax Cuts and Jobs Act (TCJA). (1) The TCJA added Secs. 1400Z-1 and 1400Z-2 to the Internal Revenue Code to create QOZs to spur economic development in depressed communities throughout the United States and certain territories by providing tax benefits to investors who make qualifying investments in these zones. In exchange for a lower capital gains rate that decreases based on the length of the investment, investors who realize gain from a sale or exchange of a capital asset or a Sec. 1231 asset (generally, property used in a trade or business that is subject to depreciation and held for more than one year) can put those dollars to work under a tax stimulus program designed to grow jobs, inspire entrepreneurship, and improve the local economy in lower-income communities designated as QOZs.

What investors might not be aware of are the powerful tax-saving opportunities of combining the QOZ benefits of investments in Puerto Rico--with most of the island designated as QOZs--with those more recently offered under Puerto Rico laws also intended to encourage economic growth in the Commonwealth of Puerto Rico, most prominently, the Puerto Rico Incentives Code of 2019, Act 60-2019 (Act 60). This article summarizes the federal tax benefits from QOZ investments under Sec. 1400Z-2 of the Internal Revenue Code, as well as the economic development and opportunity zones provisions under Act 60. (2)

U.S. and territorial communities eligible for QOZ designation (3) are (1) low-income communities, which are census tracts having (a) a poverty rate of at least 20% (high-poverty tracts) or (b) a median family income at least 20% below that in the surrounding state or territory or, for communities in a metropolitan area, below the greater of the statewide or metropolitan area median family income (low-income tracts); (4) or (2) census tracts that are contiguous with a low-income community designated as a QOZ and have a median income not exceeding 125% of that of the qualifying contiguous community. (5) Following Hurricanes Maria and Irma in 2017, Congress enacted a special provision for Puerto Rico, exempting it from the limit on the number of census tracts that could be designated as QOZs, to encourage its redevelopment. (6)

Every state, the District of Columbia, and five U.S. territories (7) have QOZs. In addition, state and local tax incentives have increasingly been targeted to eligible taxpayers that roll over capital gains from prior investments into longer-term business development investments in regions in need of economic development. (8)

However, Puerto Rico is unique in its concentration of QOZs and in how firmly it has enshrined geographically targeted economic stimulus in local tax policy. Nearly 10% of all QOZs nationwide (863 of 8,764) are in Puerto Rico--more than any other U.S. jurisdiction except California (at 879). (9) Moreover, 98% of the island is a QOZ; generally, investments in Puerto Rico are investments in QOZs.

Investments by U.S. taxpayers in Puerto Rico through mid-2027 via a self-certified investment vehicle, known as a qualified opportunity fund (QOF), operating in one of Puerto Rico's QOZs may (1) reduce capital gains, potentially permanently, from prior investments that are rolled over within 180 days into the QOF and (2) create an ability to realize tax-free gains from any post-acquisition appreciation in the value of the taxpayer's investment in such a fund after a 10-year holding period. (10)

The unique status of Puerto Rico

Puerto Rico is considered part of the United States for many federal laws but not income tax laws. Residents of the island do not pay federal income taxes on their Puerto Rico-source income. (11) Entities organized in Puerto Rico are generally classified as foreign persons, and Puerto Rico is generally treated as a foreign country under the Code. (12)

In addition to splitting tax authority with Puerto Rico, the United States has historically provided special tax incentives for U.S. corporations to make employment-producing investments in Puerto Rico, (13) which have been a primary engine of its economic growth since the late 1940s. (14) Section 1051 of the Tax Reform Act of 1976 (15) added former Sec. 936 of the Code to streamline and consolidate several special tax provisions for U.S. possessions and connected their tax credits to employment-producing investments by U.S. corporations. Sec. 936 tax credits effectively exempted U.S. corporations' Puerto Rico-source income from federal corporate income taxes and encouraged many U.S. pharmaceutical and life-science companies to transfer their intangible assets to Puerto Rico and elect Sec. 936 tax benefits. (16)

However, Sec. 936 expired in 2006. The loss of this tax benefit was considered by some as a cause of the island's subsequent long-term recession. (17) Puerto Rican officials became early advocates for opportunity zones and ultimately secured a privileged place within the federal QOZ program, which the island's leaders hope will bring more than $600 million in new U.S. investments into an economy that has shrunk by more than 22% since Sec. 936 expired. (18)

As part of the Bipartisan Budget Act of 2018, (19) Congress added a special rule for Puerto Rico. Under Sec. 1400Z-1(b) (3), all of Puerto Rico's 837 low-income communities and 26 tracts contiguous with them were automatically qualified, designated, and certified as QOZs, effective Dec. 22, 2017. The special rule exempted Puerto Rico from the limitation imposed on all states, the District of Columbia, and other U.S. possessions that no more than 25% of a jurisdiction's low-income communities could be designated as QOZs. As a result, as noted above, Puerto Rico, with less than one-twelfth the population of California, has nearly as many QOZs, and because 43% of its residents live in poverty--the highest rate in the nation--98% of Puerto Rico is designated as a QOZ. (20)

Federal tax incentives for investing in opportunity zones

Opportunity zones under the TCJA provide U.S. taxpayers, who held an estimated S6.1 trillion of unrealized capital gains as of the end of 2017, with an incentive to reinvest their capital in pockets of the country where tens of millions of Americans continue to suffer economically more than a decade after the Great Recession ended in June 2009. (21) Economic indicators suggest a similar or greater amount of unrealized capital gains are in the marketplace currently. New economic data also points toward a potentially significant increase in investment in opportunity zones. Assessing the initial impact of opportunity zones on investment, the Council of Economic Advisers estimated that by the end of 2019, QOFs had raised $75 billion in private capital, of which $52 billion, or 70%, was new investment. (22)

Taxpayers that invest in QOZ property through a self-certified QOF can defer--and in certain circumstances eliminate--the recognition of capital gains rolled over into the fund within 180 days of a capital gains recognition event. (23) The QOF must file Form 8996, Qualified Opportunity Fund, to certify each year that it reinvested at least 90% of its assets into QOZ property, including tangible property acquired by purchase or lease after 2017 that is used in a trade or business in a QOZ (QOZ business property) and stock or a partnership interest in a QOZ business (QOZB) acquired after 2017 in exchange for cash.

The 90% investment standard is determined by the average of the percentage of QOZ property held by the QOF as measured on the last day of the first six-month period and on the last day of the tax year of the QOF. (24) A QOZB is a partnership or corporation organized under the law of the United States or the law of one of the 50 states; a federally recognized Native American tribal government; the District of Columbia; or a U.S. possession, including Puerto Rico, (25) that:

  1. Holds at least 70% of its owned or leased tangible property in QOZ business property, substantially all the use of which is in a QOZ (based on the number of days'use between two consecutive semiannual QOF asset testing dates);

  2. Holds less than 5% of the unadjusted basis of its property in nonqualified financial property, including debt, stock, partnership interests, options, futures/forward contracts, warrants, notional principal contracts, annuities, and cash, other than reasonable amounts of working capital held in the form of cash, cash equivalents, and debt instruments with a term of 18 months or less for no more than 31 months from the date of receipt and spent in accordance with a written working capital plan and schedule (the working capital safe harbor);

  3. Derives 50% of its gross income from the active conduct of a trade or business in a QOZ (generally based on hours worked, salaries paid for work, or the physical location of tangible property and the operational or management functions performed within a QOZ);

  4. Uses at least 40% of its intangible property in the active conduct of such business; and

  5. Is not in the business of operating or leasing property to a private or commercial golf course; country club; massage parlor; hot-tub, suntan, or gambling facility; or liquor store. (26)

A QOZB is treated as engaged in such a "sin business" if 5% or more of its gross income, the value of its tangible personal property, or the net rentable square footage of its real property is attributable to such a business. (27)

Because QOZBs have a lower threshold for qualifying investments than QOFs (70% versus 90%) and are authorized to hold working capital for periods of 31 months or less, many QOZ investments employ a two-tiered structure: A QOF invests at least 90% of its assets in QOZB stock or partnership interests of an entity or several entities that reinvest at least 70% of that...

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