The Lifecycle of an Opportunity Zone Investment: A Six-Part Series
Exiting an Opportunity Zone Investment
As you are surely aware if you’ve read Parts 1-5 of this Series, each and every aspect of the opportunity zone investment process is both complex and, at least to some extent, fraught with uncertainty. The exit planning stage of the process is no different. This is particularly true given that exit planning requires the taxpayer to consider a hypothetical set of circumstances which is at least ten years out from the investment date. This Part 6 of the Series discusses certain key considerations in planning for that eventual exit of an opportunity zone investment.
In order to qualify for the full tax benefits available upon exiting the investment, the taxpayer must hold the investment for not less than ten years, as well as meet the other program requirements (a “qualifying sale”). In connection with a qualifying sale, the taxpayer can exclude from its taxable income all of the appreciation on the underlying opportunity zone investment. As discussed in prior Parts of this Series, the originally deferred capital gain would have already been recognized no later than December 31, 2026, after taking into account any step-up in basis.
While the opportunity zone program’s proposed regulations made a distinction between a taxpayer’s sale of a qualified opportunity fund (“QOF”) interest versus a sale of the underlying qualified opportunity zone property or business, the final regulations allowed for more flexibility in that respect. That is, gain exclusion for a QOF owner can be available for qualifying sales using a variety of (but not all) sale structures that are common in the marketplace. There are exceptions and other intricacies associated with these gain exclusion rules, however, including for example that sales of certain types of assets, like inventory sold in the ordinary course, in a qualifying sale will be taxable.
The above discussion is meant to address divestitures by a QOF after the ten year holding period has passed. Recall that there is a mechanism available to QOFs that receive proceeds from dispositions of qualified opportunity zone property to reinvest those proceeds in new qualified property within 12 months (extended to 24 months due to the Covid-19 pandemic) and not have the cash proceeds negatively affect the QOF’s 90 percent asset test. This QOF reinvestment rule, as well as the rules around other dispositions of assets by QOFs and their qualified opportunity zone business subsidiaries are beyond the scope of this post. .
As with every other component of the opportunity zone program, there are many details to be considered when considering a divestiture, including rules that address other unique circumstances, such as corporate qualified opportunity zone interests, and the treatment of capital gain dividends from real estate investment trusts (REITs). A fact-specific analysis is therefore required for each potential opportunity zone investment and each divestiture transaction by a taxpayer, a QOF or a qualified opportunity zone business.
Finally, in its critical for the taxpayer to carefully coordinate with its tax advisors and accountants to ensure all aspects of the investment exit and related financial matters are appropriately documented. For example, the taxpayer much file elections with the IRS for each taxable year in which it chooses to exclude relevant gains, and the taxpayer’s accountants must properly track the excluded gains in order to appropriately reduce the amount of the qualifying investment in light of net proceeds from the asset sales.
As has been a theme throughout this Series, there exists considerable nuances in all of the regulations discussed in this article, and all investors would be wise to consult their professional advisors well in advance of taking the initial steps to pursue an opportunity zone compliant investment. For a more in-depth discussion of the opportunity zone program, including the statute, proposed and final regulations, please read our Opportunity Zones Client Alerts which you can access via the following links: https://www.martinllp.net/category/opportunity-zone/
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While this Series will serve as a helpful primer on the opportunity zone regulations and compliance framework, the devil is always in the details. If you are considering making an opportunity zone investment in the near future, or just want to learn more than this primer can offer, the attorneys at Martin LLP are always available to consult with you.