Law: Ben Franklin and the U.S. Tax Cuts and Jobs Act of 2017

Law

By Adam M. Law

For centuries, Benjamin Franklin’s advice that “in this world nothing can be said to be certain, except death and taxes” rang true. Now, thanks in part to the U.S. Tax Cuts and Jobs Act of 2017, even that aphorism is no longer certain.

As part of the U.S. Tax Cuts and Jobs Act of 2017, socially conscious investors now have the opportunity to defer or even avoid taxes on capital gains received from the sale or exchange of an investment. Under the new tax benefit, investors can defer tax on prior capital gains if their prior capital gains are invested in a Qualified Opportunity Fund and held for less than 10 years, or even completely avoid taxation on capital gains if their investment is held in a Qualified Opportunity Fund for at least 10 years. Once an investment has been held in a Qualified Opportunity Fund for 10 years or more, the investor may elect to increase their basis in such investment to the fair market value of the investment on the date the investment is sold or exchanged, thereby eliminating any taxable gain.

Governors from each state have been given the freedom to establish Opportunity Zones comprised of census tracts within their states consisting of low-income areas in need of redevelopment and targeted business growth. Here in Indiana, all 156 census tracts nominated by Gov. Eric Holcomb have been certified and designated as Opportunity Zones by the U.S. Department of the Treasury. Within Indianapolis, much of the downtown area as well as the Fort Harrison State Park area and locations along the White River were designated as Opportunity Zones. Outside of Indianapolis, much of Crawford County and portions of Terre Haute, Lafayette, South Bend, Gary and Valparaiso were declared Opportunity Zones. According to the Treasury Department, more than 8,000 communities nationwide, home to almost 35 million Americans, are part of the newly declared Opportunity Zones.

Indiana’s Opportunity Zones were established with the help of advisers from around the state with the goal of building upon existing economic development programs, local initiatives, economic and community data and the likelihood of attracting both short- and long-term investment. In order to qualify as an Opportunity Zone, census tracts are generally required to qualify as “low-income” with either: (a) a poverty rate of at least 20 percent; or (b)(i) a median family income no more than 80 percent of the greater of the area’s median family income or the statewide median family income in metropolitan areas; or (b)(ii) no more than 80 percent of the statewide median family income in nonmetropolitan areas.

Functionally, Opportunity Zones work by allowing investors to invest through pooled investment vehicles, Qualified Opportunity Funds, which target specific Opportunity Zones, rather than directly investing into the Opportunity Zones themselves. Each Qualified Opportunity Fund is required to be certified and invest 90 percent of the funds’ assets into an Opportunity Zone business or businesses. All Qualified Opportunity Fund investments must be structured as equity investments in the Qualified Opportunity Fund, rather than as debt instruments. Each investor generally must invest in such a fund within 180 days after the sale or exchange giving rise to their capital gains. Once those capital gains are invested into a Qualified Opportunity Fund, the investor is able to defer capital gains tax on those amounts for the period such investment remains with the Qualified Opportunity Fund. If those capital gains are held in the Qualified Opportunity Fund for at least 10 years, the entire amount of capital gains will be excluded from such investors’ gross income, thereby avoiding paying capital gains tax entirely. Treasury Secretary Steven Mnuchin estimates that $100 billion in private capital would be dedicated toward creating jobs and economic growth in Opportunity Zones thanks to the new tax benefit.

Just how communities within these Opportunity Zones will market themselves to funds in order to attract investment remains to be seen. While real estate development, either in the form of commercial, residential or mixed-use, remains the likely early choice for investment, communities may very well seek to harness investment toward infrastructure, entrepreneurship or even brownfield redevelopment projects. We may also see local governmental entities seeking to partner with these funds through workforce development projects in order to draw employers to these Opportunity Zones long-term. Regardless of the uses, communities across the country will be watching this tax benefit with keen interest to ensure it is used not just as a tax avoidance tool, but also as a means to direct investment to those areas of the country that need it most.

On Oct. 19, the Treasury Department released proposed guidance on what types of gains qualify for tax deferral, who can invest in Opportunity Zone Funds and the parameters of the investments made by such funds. All across the country, that guidance currently is being reviewed by attorneys, accountants and professional advisers. Additional proposed rules are expected by the end of the year and finalized rules are expected in early 2019. While only gains treated as capital gains for federal income tax purposes are eligible for preferential tax treatment, investment is open to individuals, corporations, real estate investment trusts (REITs), partnerships and certain other pass-through entities, including trust funds and other entities taxable under §1.468B of the Income Tax Regulations.

While more legislation is likely to come further developing Opportunity Zones, the U.S. Tax Cuts and Jobs Act of 2017 has done a great deal toward eliminating one of Benjamin Franklin’s two certainties in life while also directing investment toward those areas of the country that need it most. Now, if only science will pick up the pace on the other one …•

• Adam M. Law — [email protected] — is an attorney with Taft Stettinius & Hollister LLP and a member of the firm’s real estate and business and finance practice groups. Opinions expressed are those of the author.