“Kentucky will maximize this golden chance to attract economic development projects to communities most in need across the Commonwealth, and the Kentucky Opportunity Zone Initiative will strengthen and rebuild both rural and urban areas.” Kentucky Governor Matt Bevin, April 11, 2018
The Tax Cuts and Jobs Act, Pub. L. 115-97 (the “Act”), signed into law on December 22, 2017, introduced the Opportunity Zone program (Internal Revenue Code §1400Z-1 and §1400Z-2) which provides a new federal framework for stimulating private investment in economically distressed areas across the country. In simple terms, IRC Section 1400Z-1-2 allows qualified U.S. investors to defer and potentially avoid tax on unrealized capital gains if they reinvest their unrealized capital gains in a qualified Opportunity Fund. The Fund then invests its capital, as equity, in a qualified Opportunity Zone Business located in a qualified Opportunity Zone. By targeting investment incentives to underserved census tracts, the program is intended to create jobs, drive economic growth, and improve the quality of life for the residents.
The Opportunity Zone is the focus of the program. It is created to incentivize “impact investments” in designated low-income communities identified as certified Opportunity Zones. Under the law, no more than 25% of the low-income census tracts or certain contiguous census tracts in any one state can be designated as Opportunity Zones and it is up to the Governor of each state to submit a list of census tracts for approval. On March 21, 2018, Governor Bevin, on behalf of the Commonwealth, nominated the maximum number of census tracts as Opportunity Zones and then on April 9, 2018, the U.S. Department of the Treasury and the Internal Revenue Service designated 144 urban and rural census tracts in 84 Kentucky counties as qualified Opportunity Zones. It is reported that over half the Kentucky designated communities had fewer jobs and fewer businesses in 2015 than in 2000. The Kentucky Cabinet for Economic Development will oversee the Commonwealth’s program through the Kentucky Opportunity Zone Initiative and www.KYOZ.org will provide ongoing and up-to-date information in interactive maps of all of the Kentucky Opportunity Zones.
The process begins with the Qualified Opportunity Fund. It is the mechanism for connecting investors to investment opportunities in Opportunity Zones. A Qualified Opportunity Fund is a private sector investment vehicle treated as a corporation or partnership for federal income tax purposes. The sole purpose of this Fund is investing and holding its assets in Qualified Opportunity Zone Property. At this time there are no limits on the number of Qualified Opportunity Funds nor are there any limitations on the dollar amount of the investment made by a Qualified Opportunity Fund; or the total number of investments that any one Qualified Opportunity Fund can make. Qualified Opportunity Funds are subject to self-certification which means a fund simply needs to complete a form and attaches that form to its federal income tax return for the taxable year. Consequently, there is no preapproval required by the IRS.
A Qualified Opportunity Fund must invest and hold at least 90% of its assets in Qualified Opportunity Zone Property. Qualified Opportunity Zone Property includes (i) Qualified Opportunity Zone Stock; (ii) Qualified Opportunity Zone Partnership Interests; and (iii) Qualified Opportunity Zone Business Property. Qualified Opportunity Zone Stock is defined as original issued stock of any domestic corporation acquired by an Opportunity Zone Fund, for cash, after December 31, 2017, and which, at the time the stock is issued and during substantially all of the Opportunity Fund’s holding period, the corporation is a Qualified Opportunity Zone Business. If the corporation is newly formed, it does not need to constitute a Qualified Opportunity Zone Business on the date the stock is issued, but it must be organized for the sole purpose of being a Qualified Opportunity Zone Business. Qualified Opportunity Zone Partnership Interests are interests in a partnership with requirements substantially identical to those applicable to Qualified Opportunity Zone stock. Finally, Qualified Opportunity Zone Business Property is tangible property used in a trade or business if such property: (i) was acquired by purchase after December 31, 2017; (ii) the original use of such property in the Qualified Opportunity Zone commences with the Qualified Opportunity Zone Business or the Qualified Opportunity Zone Fund substantially improves the property; and (iii) substantially all of the use of such property was in a Qualified Opportunity Zone during substantially all of the Qualified Opportunity Fund’s holding period for the property. Qualified Opportunity Zone Business Property will be treated as substantially improved by a Qualified Opportunity Fund only if, during the 30 month period beginning after the date of acquisition, the additions to the basis of such property, in the hands of the Qualified Opportunity Fund, exceed the adjusted basis of such property at the beginning of the 30 month period.
Finally, Qualified Opportunity Zone Property must be used in a Qualified Opportunity Zone Business. A Qualified Opportunity Zone Business is defined as a trade or business where: (i) substantially all of the tangible assets of the business are used in a Qualified Opportunity Zone; (ii) at least 50% of its gross income must come from the active conduct of a trade or business in the Qualified Opportunity Zone; (iii) it holds a limited amount of investment property; and (iv) it is not engaged in owning or operating any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Upon checking off all the boxes, an investor/taxpayer will be allowed to defer income tax imposed on short-term or long-term capital gains due if the capital gains portion of the sale or disposition is reinvested within 180 days in a Qualified Opportunity Zone Fund. If the investment is maintained in the Qualified Opportunity Zone Fund for five years, the investor will receive a step-up in tax basis equal to 10% of the original gain and if the investment is held in the Qualified Opportunity Zone Fund for seven years, the investor will receive an additional five percent step-up in tax basis. A recognition event will occur on Dec. 31, 2026, in the amount of the lesser of (i) the remaining deferred gains (accounting for earned basis step-ups) or (ii) the fair market value of the investment in the Qualified Opportunity Zone Fund. Importantly, investments maintained for 10 years and through Dec. 31, 2026, will allow for an exclusion of all capital gains from post-acquisition gains on the investments in a Qualified Opportunity Zone Funds.
With a reported $2.0-$6.2 trillion of unrealized capital gains in stocks and mutual funds held by individuals and corporations, Kentucky is poised to maximize this unique opportunity to drive investment capital to communities most in need. However, it is much too early to gauge the impact of this program. First of all, the U.S. Treasury must promulgate the program’s rules and regulations which ensure that investments are made in ways that will both generate an acceptable return to investors and ensure that the local community objectives are met. It is likely that it will be late fall before guidance is issued. Second, and equally important, state and local governments must, from the start, participate in a meaningful manner by creating an environment that remove barriers to economic growth and promotes innovation and productivity. Money, in and of itself, will not be enough. A strong, well-thought out and aggressive public-private partnership with a focus on community revitalization and reconstruction is required for the Opportunity Zone program to succeed in the Commonwealth.