Although the corresponding final regulations are not yet available, the opportunity zone tax law passed in 2017 has generated significant buzz among investors, business owners, and community groups. The law, codified in Internal Revenue Code Sections 1400Z-1 and 1400Z-2, incentivizes new investment in businesses and real estate in designated low-income communities throughout the United States. The law is expected to unlock significant investment but is also controversial because of the lack of reporting requirements, the open questions surrounding the degree to which low-income people will benefit from the law, and the rich benefits it offers investors. Under the law, investors can receive tax deferral and tax elimination, including the complete elimination of capital gains from qualifying investments held for more than ten years.[i] The law may also provide an added benefit to investors: a way to improve their tax position through the strategic use of debt. Unless regulators restrict the tax benefits available to investors who leverage their opportunity zone equity investments, those investments may produce significant benefits throughout the investment term, not only at disposition.
In the landmark tax case, Crane v. Commissioner (1947),[ii] the Supreme Court held that the amount of a nonrecourse mortgage is included in the basis of a property, a determination significant for calculating a gain on sale or exchange but also for the purpose of determining the amount of depreciation deductions available to a taxpayer. Depreciation deductions allow taxpayers to reduce their income tax liability by deducting from income a portion of an asset’s basis, according to an IRS-allowed depreciation schedule.[iii] But these deductions are not “free”; they are offset by reductions in the property’s basis, increasing the tax liability to the taxpayer upon the disposition of the property. The Crane decision was significant—indeed, opening the door to many forms of tax avoidance—because it allowed taxpayers to obtain major tax benefits by financing investments with debt. By doing so, investors could enjoy depreciation deductions generated by property much more valuable than their own equity investments. Even if a future tax bill were higher because of the reduction in basis, the investors would benefit from years of tax deferral. But the petitioner in the Crane case, Beulah Crane, tried to take this benefit one step further. She used her apartment building’s debt value when calculating depreciation deductions but omitted the debt value when calculating the amount realized when she sold the property.[iv]
While Crane’s attempt to whipsaw the IRS was inconsistent with the Court’s holding—she lost the case—the opportunity zone law may allow investors to accomplish a similar result. Although IRC § 1400Z-2 stipulates that equity investments made in opportunity zone funds shall have a zero basis,[v] the Crane decision suggests that an investor may enjoy a large basis in an opportunity zone investment through the use of debt, since the amount of a mortgage will be included in basis. This is significant because the depreciation deductions would probably not contribute to a higher tax bill in the future, as gains will be excluded as long as the investment is held for more than ten years.[vi] Although the investor’s basis would be reduced each year according to the depreciation deductions taken, the opportunity zone benefit would allow a step up in basis to fair market value at disposition after ten years, [vii] assuming the investor complied with all of the required opportunity zone rules. Assuming investors are able to benefit from leveraged investments in this way, the new law may bring more tax-driven, rather than fundamentals-driven, investment to the designated low-income communities. If this happens, the law’s supposed alignment of interests between investors and communities—through its focus on long-term, fundamentals-driven, equity investments, might be significantly eroded. Final regulations are expected in the coming months. Stay tuned.
[i] See26 U.S.C. § 1400Z-2(c) (2017).
[ii] Crane v. Comm’r of Internal Revenue, 331 U.S. 1 (1947).
[iii] E.g., 26 U.S.C. § 168 (2015).
[iv] Crane, 331 U.S. at 1. Although this was the fact pattern leading up to the case, Crane’s legal arguments to the Court were different; in her brief, she did not defend her attempts to whipsaw the IRS. Brief for Petitioner, Crane v. Comm’r of Internal Revenue, 331 U.S. 1 (1947) (No. 68).
[v] See26 U.S.C. § 1400Z-2(b)(2)(B)(i) (2017).
[vi] See26 U.S.C. § 1400Z-2(c) (2017).
[vii] Id.