By Austin Bowlin, CPA
Economic Opportunity Zone Funds (EOZs) have received a significant amount of attention since their creation through the Tax Cut and Jobs Act of 2017. Owners of highly appreciated investment real estate have asked if these funds present a better tax strategy than 1031 exchanges. Like many good questions, the answer is “it depends.” This month we will provide an overview of EOZs, followed next month by an analysis of whether they are more, or less, advantageous than 1031 exchanges.
Economic Opportunity Zones are defined as underdeveloped areas in which the state would like to motivate investment. In early 2018, nominated areas were selected by each state’s governor to be reviewed by the US Treasury Department. In Washington State, the criteria for nominating an EOZ was a census tract with either an individual poverty rate of 20%+ or median family income within the census tract at 80% or less of the area median income. Once nominated, Governor Inslee’s office could select 25% of the qualifying census tracts to receive the EOZ designation. The State’s website says this narrowing down process considered and involved “a diverse group of stakeholders” however some individuals have noted the selection process was both rushed and not entirely transparent as to the framework utilized, both in Washington State and many other states. Of the 565 eligible Washington State census tracts, 139 received an Economic Opportunity Zone designation.
The intent of the designation is to motivate investment and job creation within the zone via generous tax incentives. The investment must be made through a “Qualified Opportunity Zone Fund” and is self-reported by the tax-payer. Investments can be either in a business entity or real estate, however the investment must be made following the passage of the tax reform bill signed in December 2017. It is important to note there is a requirement that any property purchased by an EOZ Fund be “substantially improved or enhanced.” Throughout the coming years, litigation in tax courts will serve to further define “substantially improved or enhanced,” however most are operating under the assumption that an equal investment used to acquire property must be deployed to improve the property over the 30-month period following the acquisition.
The tax treatment associated with EOZs is very generous and is as follows: any asset sold at a gain following June 2017 can reinvest the gain in a Qualified OZ Fund within 180 days and receive preferential treatment. A qualified intermediary is not required to facilitate the reinvestment (as they are with 1031 exchanges), instead the reinvestment is self-reported by the investor. Furthermore, the investor can receive sales proceeds equal to their taxable basis free of any tax at the time of the sale as only the gain is required to be invested. Once reinvested in a Qualified OZ Fund, the amount of taxable gain will be reduced by 10% in year 5 and an additional 5% in year 7. Furthermore, any appreciation of the investment in the EOZ fund will not be taxable at the time of sale of the fund’s assets. Lastly, the tax associated with the deferred gain cannot be deferred indefinitely (as you can with a 1031 exchange) but will come due on December 31, 2026.
There are both advantages and disadvantages to investing in Economic Opportunity Zones. Hopefully this overview serves to familiarize you with the general structure and concepts of EOZs. Next month we will discuss whether 1031 exchanges or EOZ Fund investments are more advantageous, considering different investor profile and objectives.