The Land of Opportunity Zones: Deferring Taxable Capital Gains Through Investments in Low-Income Communities.

• Author: Vardell, Reid S.

1. INTRODUCTION

   The market reserve of unrealized capital gains in the United States has grown to an estimated $6 trillion. (1) A new program provides a novel way to incentivize investors into realizing those gains but deferring recognition, while at the same time helping to revitalize areas of America that need it most. (2)

   The opportunity Zone Program is a tax deferment scheme that serves as a tool to bring capital into underperforming areas (3) by giving preferential tax treatment to realized capital gains reinvested in specific communities. (4) The program aims to remedy the "profoundly uneven" economic recovery in the United States following the Great Recession of December 2007 to June 2009 where many areas still face high unemployment and low job opportunity despite robust economic recovery in more resilient urban areas. (5) When jobs leave an area and unemployment increases, private investments and businesses start to move elsewhere. (6) This causes a hollowing out of the area's tax base and a decline in revenue for local governments. (7) Many workers stay in these distressed areas of high unemployment either by choice or necessity, (8) which places a higher burden on the local government and established social safety nets. (9) Economic concerns aside, workers in these distressed areas face higher instances of death or major illness, and their children are confronted with lower achievement outcomes and wages later in life. (10) Many communities find themselves in this widening gyre where investors are reluctant to return to an area because of the lack of other investors. (11) Congress designed the Opportunity Zone Program as a tool to drive private equity capital back into these under-performing areas and jump-start the economic recovery process. (12)

   This Note provides a discussion of the capital gains tax as a backdrop to the Opportunity Zones Program now found in Section 1400z of the Internal Revenue Code (the "Code"). The Note then examines aspects of the program that could lead to the program's success as well as some issues that could delay the program's adoption. Finally, the conclusion will juxtapose the Opportunity Zone Program with the New Market Tax Credit (the "NMTC") to evaluate the program's potential for overcoming past hurdles.

2. LEGAL BACKGROUND

   The United States first introduced an income based tax to offset the mounting cost of the Civil War. (13) It was not until the ratification of the Sixteenth Amendment to the Constitution that the concept of a federal income tax became a cornerstone of American taxation. (14) At the time, the Code taxed all income at the same rate, regardless of its source. (15) This changed with the passage of the Revenue Act of 1921, which granted capital gains a substantially more favorable rate than ordinary income. (16)

   Capital gain is realized "from the gain on the sale or exchange of a capital asset." (17) If the sale or exchange results in a loss, a capital loss is realized instead. (18) Realized gains or losses generally must be recognized at the time they occur unless some non-recognition provision can be found in the Code. A capital asset is any "property held by the taxpayer," subject to a number of exceptions, including inventory, property used in a trade or business subject to depreciation, all real property used in a trade or business, and patents or inventions in the hand of the creator. (19) In the words of the Internal Revenue Service, "Almost everything you own and use for personal or investment purposes is a capital asset." (20)

   Capital gain or loss is generally the difference between the amount the taxpayer receives for the asset and the taxpayer's basis in the asset. (21) A taxpayer's basis in a capital asset consists of costs paid to acquire the asset increased by capital expenditures made to improve it. (22) Capital gains are long-term if the asset is held for over one year or short-term if the asset is held for one year or less. (23) The Opportunity Zone Program targets these unrealized capital gains.

3. THE OPPORTUNITY ZONE PROGRAM

   The strong Republican showing in the 2016 national election set the stage for the largest overhaul of the Tax Code in over thirty years. Republicans gained control of the executive branch while maintaining their majority in both houses of Congress. (24) Changes came in the form of Public Law 115-97, better known as the Tax Cuts and Jobs Act ("TCJA"). (25) The TCJA had the dual goals of reducing tax burdens and simplifying the Tax Code but it managed to further complicate the taxation of capital gains with the inclusion of Subchapter Z--Opportunity Zones. (26) The Economic Innovation Group ("EIG") first proposed Opportunity Zones in a 2015 paper entitled "Unlocking Private Capital to Facilitate Economic Growth in Distressed Areas." (27) The Opportunity Zone Program has since gained bipartisan support during its implementation. (28)

   1. Additions to the Code

      Under the program, a taxpayer can defer recognition of realized capital gains by investing those gains into underprivileged or underperforming regions designated as Opportunity Zones. (29) This section examines how Qualified Opportunity Zones are created, what requirements are imposed on Qualified Opportunity Funds ("QOFs") and Qualified Opportunity Zone Businesses, and the types of property under the expansive umbrella of Qualified Opportunity Zone Property before finally looking at the treatment of realized capital gains invested with QOFs.

      1. The Creation of Qualified Opportunity Zones

         A Qualified Opportunity Zone is defined as "a population census tract that is a low-income community." (30) To be considered a low-income community, a tract must either have: (1) a poverty rate of at least twenty percent, or (2) have a median income at or below eighty percent of the statewide median income. (31) Currently, no new Qualified Opportunity Zones can be created. The designation process in the Code is limited to the ninety day window after the enactment of the TCJA with a possible thirty day extension. (32) The Code grants designation authority to the highest state executive officer and mandates that those governors report selected census tracts to the Treasury Secretary. (33) The Code then gives the Secretary thirty days to certify the tract. (34) The designation lasts until "the close of the 10th calendar year beginning on or after such date of designation." (35)

         The Code also restricts the number of Qualified Opportunity Zones available to a state to no more than "[twenty-five] percent of the number of low-income communities in the State." (36) The program guarantees states with less than 100 low-income communities a minimum of twenty five nominations. (37) The statute also grants Puerto Rico Qualified Opportunity Zone status in its entirety. (38) A tract that does not qualify as a low-income community can be designated as a Qualified Opportunity Zone if it is "contiguous with the low-income community that is designated as a qualified opportunity zone" and the income for that tract does not exceed "125 percent of the median family income of the low-income community with which the tract is contiguous." (39) Bringing capital to these communities and having the capital considered a qualified investment is the job of QOFs. (40)

      2. The Moving Parts: Qualified Opportunity Funds, Qualified Opportunity Zone Businesses, and Qualified Opportunity Zone Business Property

         A QOF is defined as "any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone Property," but the investment cannot include another QOF. (41) QOFs self-certify by attaching a form to their tax returns and do not require government approval or certification before investing. (42) QOFs must hold at least ninety percent of their investments in Qualified Opportunity Zone Property and are audited twice a year--once at the end of the sixth month of their taxable year and again on the final day. (43) Currently, the ninety percent test relies on the QOF's financial statement or, in the absence of any statement, the cost of the fund's assets. (44) To encourage QOFs to maintain the required amount of Qualified Opportunity Zone Property, the Code imposes a penalty against QOFs that drop below the ninety percent investment level, unless the deficiency is due to reasonable cause. (45) The penalty is proportional to the fund's deficiency. (46)

         Current proposed regulations suggest including cash as Qualified opportunity Zone Property for purposes of the ninety-percent asset test. (47) Prior to this, investors expressed worries that the economic realities of developing a new business or real estate transaction might require a QoF to hold large amounts of cash for longer than six months, which would result in a penalty if the cash constituted more than ten percent of the QOF's total assets. (48) While not finalized, the plan would allow cash to be held for a period of thirty-one months only if the fund has a written plan and schedule for the deployment of the capital. (49)

         A Qualified opportunity Zone Business is a trade or business that has "substantially all" of its owned or leased tangible property as Qualified Opportunity Zone Property. (50) It must derive at least fifty percent of its total gross income from active business within the Qualified opportunity Zone, and that active business cannot be an excluded business activity. (51) Qualified Opportunity Zone Businesses are prohibited from having non-qualified financial property, such as debt, options, or future contracts, make up more than five percent of their assets. (52) The Treasury has proposed defining "substantially all" in relation to ownership of tangible property as seventy-percent of the business's owned or leased tangible property. (53)

         Qualified opportunity Zone Property encompasses Qualified opportunity Zone Stock, Qualified Opportunity Zone Partnership Interests, and...