When Congress passed the Tax Cuts and Jobs Act (TCJA) at the end of 2017, they introduced a new tax incentive for capital investors. The Qualified Opportunity Zone (QOZ) program defers (and potentially eliminates) individuals’ capital gains taxes when they finance capital improvements in pre-approved, economically depressed land tracts called opportunity zones. The QOZ program has been operational for more than two years now, but many taxpayers are just now dipping their toes into the process.

In December, the IRS and the Treasury Department released final regulations for the program (TD 9889) that clear up some ambiguities in the law that became apparent once the program was put into practice. With help from these regulations, investors now have a clear path forward.

What wasn’t in the law or described in the regulations was how beneficial the program could be for construction businesses. Contractors, builders, engineering firms, developers and other construction businesses can benefit from the program as well.

Benefits to Investors

The program incentivizes individuals to reinvest their capital gains into building projects and businesses that serve low-income neighborhoods. In return for their capital investments, taxpayers are rewarded with the following:

Capital Gains Tax Deferral: If a taxpayer invests capital gains into an opportunity zone within 180 days of the sale, they can postpone their gain recognition until Dec. 31, 2026.

Step-Up in Tax Basis: In addition to gain deferral, investors can step-up the tax basis of their investment to effectively eliminate 10% of their gain. To qualify for this benefit, they must invest on or before Dec. 31, 2021, and hold their funds in an opportunity zone for at least five years.

Permanent Tax Exclusion: If a taxpayer holds their investment in an opportunity zone for at least 10 years, they can permanently exclude taxes on the appreciation that occurred within the zone.

There is one catch. To receive these benefits, taxpayers must invest their gains into an intermediary called a qualified opportunity fund (QOF). QOFs are investment vehicles created to support QOZ investment. QOFs inject capital into construction or real estate businesses, which then use those funds to improve property in the QOZ.

Benefits to Construction Businesses

Construction businesses do not directly benefit from the QOZ program, but they certainly indirectly benefit from it. As QOFs begin accepting taxpayer funds, they will be searching for new building projects. Construction businesses will have more projects to choose from and can select the project that best aligns with their existing workload.

Alternatively, builders can start their improvement projects, and they can use the QOZ tax incentives to solicit investment directly from taxpayers.

To accept capital investments, construction businesses must work with an existing QOF or operate one directly. QOFs are simple entities to manage, so their most significant concern should be operating in a manner that qualifies them as a QOZ business. Under the program, QOFs can only invest their assets in QOZ businesses if those businesses meet the following four tests.

1. Substantially all their tangible assets are owned or leased in the QOZ.
2. At least 50% of their gross income is from the active conduct of a trade or business within the QOZ.
3. A substantial portion of their intangible property is used in the active conduct of a trade or business in the QOZ.
4. Less than 5% of their property is nonqualifying financial property.

And lastly, construction companies can invest their businesses’ funds into their projects. If they have the cash to invest, unrealized capital gains and willing owners, they can receive the step-up in basis or tax elimination just like individual investors. Discussing such a unique investment with their owners will require some finesse, but a contractor or design firm can take advantage of the tax deferral or elimination.