Does the current state of the stock market have you worried? With the volatility of the current market, individuals are selling off their stock positions and looking for more stable investments. Those individuals then may face significant tax exposure as a result of capital gains. To those individuals, it may be worth exploring Qualified Opportunity Zones (QOZ’s). There are designated QOZ’s in all 50 states and U.S. territories allowing for a plethora of choices for an investment.
What are Qualified Opportunity Zones?
As part of the Tax Cuts and Jobs Act, December 22, 2017, Congress added two tax incentive provisions focused on encouraging investment areas known as QOZ’s. These are community-nominated geographical areas of historically-underutilized zones or neighborhoods approved by the state and certified by the Treasury Department. To date, there are approximately 8,700 zones nationwide which can be viewed on this map. The program’s intention is to encourage the private sector to utilize gains from highly-appreciated assets as investments in economically-challenged communities. This allows for wealth building and revitalization in areas that have historically been underutilized. The benefit to investors is straight forward: by providing an influx of capital in geographic areas in need of private investment, investors can defer, reduce or even avoid taxes on certain gains if the investment is held for 10 years, as well as achieve a new means of portfolio diversification. The benefits to the community are wide-reaching. This influx of capital has the potential to provide increases in employment, economic activity, increased housing, and overall community development in these areas.
How do Qualified Opportunity Zones Work?
Generally, within 180 days of the sale or exchange of assets generating a gain, the taxpayer chooses to reinvest any portion of the gain in a Qualified Opportunity Fund (QOF). The QOF conducts business by holding a business property, stock, or a partnership interest in a QOZ. This gain is then deferred until December 31, 2026, or earlier should the taxpayer divest or exchange the QOF. Depending on how long the taxpayer holds the investment, temporary gain deferral becomes permanent. The tax on that gain is also deferred, allowing the investor access to additional available cash for increased investment. To obtain the tax advantage of the deferred gain, a taxpayer must hold the investment for 5 years. If the taxpayer holds the investment in the QOF for 7 years an additional 5% of gain is excluded. Once the investment is held 10 years all gain is excluded. Timing is key to obtaining this maximum deferral. Since the law sunsets in 2026, an investment in 2019 would only provide a 15% savings in capital gains tax – the first 10% recognized after five years and the next 5% recognized at the seven-year mark in 2026. At this point, the provision would have to be extended by Congress. Many other frequently asked questions are answered through the IRS’s webpage.
Making the Election – In order to make the election, the taxpayer completes Form 8949 “Sales and Other Dispositions of Capital Assets” and submits it with their individual tax return for the year of the sale. In order to qualify for the deferral of taxes, the investor does not need to invest the entire sales proceeds, merely the entire amount of eligible gain. This allows for the initial investment to generate cash for subsequent investment (original purchase price) as well as defer taxes on the gain from the sale. If you have already filed your tax return, you can still elect to defer tax on the gain by filing an amended return and attaching Form 8949.
Qualified Opportunity Fund (QOF) – This is a partnership or corporation formed to invest in qualified opportunity fund property. For the fund to qualify it must invest at least 90% of its assets in qualified opportunity zone property. While the legislation was written to include investments in companies and real estate the first set of regulations makes it difficult to invest in an operating business. The proposed regulations released in April clarified these direct investments and also provided clarification for advantageous treatment of capital gains for businesses that move to and operate for 10 years in qualified opportunity zones.
Direct Investment in QOZ Property – The Investment must be through a qualified opportunity fund (QOF). The investor does not make a direct investment in property. When a QOF invests directly in a business in a QOZ or in property in a QOZ there are specific requirements. Simply acquiring property that currently resides in a QOZ will not qualify without substantial improvements. The substantial improvement requirement specifies that the property have its basis doubled within 30 months. The definitions of a property are not specific only that the property be used in a trade or business.
Investment in rental activities poses another area of uncertainty. The IRS has historically viewed certain rental activities involving a triple net lease as an investment rather than a Sec. 162 trade or business. If this is the case, then if a QOF or subsidiary constructs a building that is rented, for example, to a tenant on a triple-net basis, the IRS may take the position that the building is not used in a trade or business and should not qualify as QOZ business property. This should be part of the QOF due diligence, but investors should be aware.
Investments are not limited to real estate. Included in the provision are stock/interests in qualified opportunity zone businesses, development of a new business, expansion of businesses to a QOZ or larger expansion of a business currently in operation in QOZ. There are specific challenges in investing in a non- real estate operating business. These non-real estate operating businesses must address a 50% income test – 50% of income each year must be earned from within the QOZ. There are various safe-harbors available to satisfy this test. As for what types of business may be eligible, the current legislation only identifies the following as “Disqualified Businesses”:
- Any private or commercial golf course
- Country club
- Massage parlor
- Hot tub facility
- Suntan facility
- Racetrack or other facility used for gambling or
- Any store, in which the principal business is the sale of alcoholic beverages for consumption off the premises
Eligible Taxpayers – these include individuals, C Corps (including REITS and RICS), partnerships, S Corps, and trust and estates. Specific guidelines on whether gain is recognized at a partner or entity level exist that create increased flexibility for partnerships.
Eligible Gain – to be an “eligible gain” the transaction must not be from an exchange with a related party. The sale transaction may include a wide variety of capital assets sold or disposed of by investors: land, developed real estate, stocks, bonds, crypto-currencies, artwork, collectibles as well as tangible and intangible assets. Any gain that arises from an actual sale or deemed sale or exchange that is “treated as capital gain” is considered “eligible gain”. If the gain occurs as a result of selling income-producing assets (Sec 1231 assets) but that gain is treated as capital gain, that would be an eligible gain for deferral. There are some complex issues involving the netting of Sec. 1231 gains and losses that taxpayers need to address in determining eligible gain. If depreciation was claimed while the investor held the asset, this depreciation is recaptured and taxed as ordinary income. The recapture would not be an eligible gain.
The temporary deferral of capital gains to the extent the gains are reinvested into a QOF. For example, if a taxpayer sells an investment with zero basis for $1 million, resulting in a $1 million capital gain. The money is then invested in a QOF or a direct investment in QOP. None of the sale proceeds are taxable in the year of sale. That would result in a $200K deferral of capital gains tax in the year of the sale based upon a 20% capital gains rate. That money that would have been paid in taxes could provide a significant return to the taxpayer depending upon the investment.
Partial exclusion of the temporary gain and increase in basis when the investor meets certain holding period requirements. In addition to postponing “eligible gain”, investors can receive a “step-up” tax basis on 10% of their investment after holding the investment for five years. An additional “step-up” of 5% is available if the investment is held for 7 years; thus, reducing the tax obligation by 15% payable by December 31, 2026. The tax basis of the entire investment automatically steps up to the FMV of the investment if held for 10 years. Meaning you will not pay any tax on the appreciated basis. However, in order to ensure qualification of the 15% step-up in basis, you must invest any qualified gain by the end of December 2019 due to the provision’s expiration date of December 31, 2026.
Permanent exclusion of the “post-acquisition gains” from the sale of an investment held for longer than 10 years.
Investments in QOZ are not subject to estate taxes if transferred to a surviving spouse, estate or trust upon death. However, deferred gains may become taxable if the QOZ investment is gifted during the lifetime of the original investor.
In conclusion, the innovation of Opportunity Zones offers investors substantial tax benefits and revitalizes historically economically distressed communities. Using market-based approaches to improve economic conditions in under-served communities, investors have the opportunity to transform thousands of areas of distressed communities while availing themselves of very advantageous tax incentives. Across the nation, these opportunities are having a profound effect on lives and motivating investors to rethink traditional investment strategies. Accessing numerous tax-saving incentives while providing the chance to redefine social involvement is something that benefits everyone involved.
Contributing author: Ernie Giaco, CPA | Tax Manager
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