Real Estate

Z is for (opportunity) zone

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Posted by Courtney Kopec, CPA

If you are holding appreciated property that you are looking to offload, but don’t want to pay income tax on the appreciation right now, then Congress has a solution for you: Qualified Opportunity Zones. This is an incredibly taxpayer-friendly provision that was included in the Tax Cuts and Jobs Act.

Get in the Zone

Congress passed Subchapter Z to entice private investors to invest in low-income urban and rural areas by providing “temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund.” Translation: under this law, an investor may defer any gains from the sale of property to an unrelated party by reinvesting the capital gains portion of the proceeds in a qualified opportunity fund (“QOF”) within 180 days of the sale. The gains are deferred until the QOF is sold or exchanged, with the tax benefits increasing substantially the longer the holding period of the fund (up until December 26, 2026, the law’s tax recognition date). The principal cost portion of the sale proceeds does not need to be reinvested, and there is no tax benefit in doing so.

The best-case tax savings scenario is where an investor reinvests realized capital gains in a QOF by December 31, 2019, and the QOF is held for 10 years. In this scenario, on December 31, 2026 the taxpayer holding the QOF recognizes and includes gain in gross income as calculated to that date. The original reinvested deferred gain is reported and 15% of that deferred gain is treated as additional or “stepped-up” basis. This reduces the amount of the original reinvestment to be taxed by the 15% stepped up basis. Thereafter, if the fund is held for the full 10 years, no additional capital gains will be recognized. But the law contains other requirements and lesser tax savings scenarios that make the Qualified Opportunity Zones a tax savings opportunity that should not be overlooked, even if a shorter holding period is desired.

What is a Qualified Opportunity Fund?

A QOF is an investment vehicle designated by IRS guidelines and qualifications. No approval or action by the IRS is required to establish a QOF. The fund self-certifies and can be a partnership, corporation, or limited liability company. QOF requirements do include some technical guidelines. For example, the fund must hold at least 90% of its assets in QOZ Property (“QOZP”). QOZP includes QOZ stock, a QOZ partnership interest, or QOZ business property in a Qualified Opportunity Zone. QOZP must be acquired after December 31, 2017 in exchange for cash.

A qualified zone business owns or leases substantially all of its tangible property in QOZ business property and generates 50% of its income from active trade or business with “less than 5% of the average of its aggregate unadjusted bases of the property of such entity attributable to nonqualified financial property.” Investments in certain “sin” businesses are not eligible investments. A penalty is assessed each month the QOF fails to meet compliance requirements referred to above.

What is a Qualified Opportunity Zone?

A QOZ is an economically-distressed area where under certain conditions, new investments may be eligible for preferential tax treatment. Governors were asked to nominate low income urban and rural areas for Treasury approval to become QOZs. The current list of designated QOZs can be found here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx

Death and taxes? Perhaps not: deferral and abatement

The primary benefit of investing in an QOF is the deferral of reporting taxable gains. Because QOF investors are reinvesting the capital gains portion only and deferring the tax to a future date, their initial reinvestment has no cost basis. An investor who holds a fund for a minimum of five years and initiates the investment by December 31, 2021 will be deemed to have a basis equal to 10% of the reinvested funds on December 26, 2026, the law’s tax recognition date. In other words, by satisfying the investment date and holding period requirement, $100,000 invested in a qualified fund with no basis now qualifies for a deemed $10,000 stepped-up basis. And due to the deemed basis, the taxpayer pays tax on only $90,000, instead of $100,000. For an increase in the tax savings benefits to be considered, the reinvested capital gains must be invested in a QOF by December 31, 2019 and held for seven years. If the Fund invests by year end 2019 and satisfies the seven-year holding period requirement, the investment qualifies for a 15% stepped-up basis. If the fund is held ten years, the basis is stepped up, and deemed to be equal to the fair market value. Therefore, after ten years, no tax is paid on the appreciation of the gains reinvested in the fund. Sweet, sweet tax benefits!

Tax planning considerations

Subchapter Z presents real estate developers an opportunity to establish a fund in order to generate third-party investment capital for their projects. But! QOFs that choose real estate as a primary holding in the fund must meet mandated rehabilitation requirements. For real estate investors with large gains considering a 1031 exchange, the opportunity fund is a viable alternative option in that it requires only gain to be reinvested. However, additional cash invested will be treated separately and will not be eligible for the capital gain exclusion.

Bottom line? The alternative capital gain tax deferral option offered by the fund vehicle is more liquid than reinvesting in another real estate property. In the least favorable scenario, if an investment is held fewer than five years, the gain is deferred until the sale, but no gain is excluded.

Is Subchapter Z right for you? Contact your CPA or trusted advisor to make that determination.

Further reading

Pitfalls of the New IRS Interest Expense Limitation

Posted by Evan Piccirillo, CPA

EDITOR'S NOTE: This article is also featured in the August 7, 2018 edition of the New York Real Estate Journal.

The sweeping revision to the U.S. tax code known as the Tax Cuts and Jobs Act contains many provisions that present pitfalls and planning opportunities.  One such provision limits the tax deduction on interest expense.  This presents certain tax-planning considerations for taxpayers, especially those who do business relating to real estate.

Under the revised code, the federal tax deduction for net business interest expense is limited to 30% of a taxpayer’s “adjusted income” at the entity level, with the excess carrying forward indefinitely.  Adjusted income under this provision is business earnings before interest, and until tax years beginning in 2022, before depreciation and amortization as well.  Net operating losses and the new 20% pass-through deduction are ignored when determining adjusted income.  For example, in 2019 a taxpayer has $40 of taxable income, $30 of interest expense, and $10 of depreciation and amortization.  Adjusted income is $80 ($40 + $30 + $10) and the limit on interest deduction is $24 ($80 * 30%).  In this case, $6 ($30 - $24) carries forward to the subsequent year.

This limitation is a detriment to taxpayers who finance a significant portion of their operations with debt, which is common when operating rental real estate.  Furthermore, rental property debt is often refinanced in order to distribute cash representing the appreciation of the property’s value, usually to fund additional acquisitions.  Since the debt doesn’t go away the excess interest may keep carrying forward, in effect permanently.  Some businesses may have to consider changing their method of financing operations to shift from debt to equity to counter the limitation.

Fortunately, in certain situations taxpayers can avoid limiting their interest deduction.  

The Small Business Exemption

Taxpayers with average gross receipts of less than $25 million over the previous three years ($25M test) are exempt from the interest limitation described above.  Since $25M is a high threshold, many taxpayers will be relieved to hear about this exemption, if not for the following pitfalls:

Pitfall 1 - Aggregation rules

The $25M test for the small business exemption is applied using somewhat complex aggregation rules.  Receipts from entities with common ownership are grouped together for the test.  If the group fails the $25M test, the entities in that group will not be able to avoid the limitation this way.  For example, two rental properties are owned in partnerships by two individuals, split 50/50.  Each property has average gross receipts of $15M, well below $25M.  But the receipts of these properties are combined for the small business test.  In this case, $30M is greater than $25M, so both partnerships fail the test and are subject to the limitation.  This provision is meant to counter the obvious strategy of splitting up existing businesses into smaller companies to avoid the limitation.

Pitfall 2 - Entities with limited investors

Taxpayers who realize taxable losses and have more than 35% of their ownership comprised of limited investors may also fall into the “tax shelter” trap.  Consider a rental property owned by a partnership of five individuals, each with a 20% interest.  Three partners are actively engaged in the business; the other two are limited partners. If the property experiences a tax loss in a given year, it is considered a “tax shelter” in this context, since a ratable amount of the loss is allocated to the two limited partners whose ownership exceeds 35%.  In this case, the small business exemption does not apply, regardless of the results of the $25M test; therefore the interest deduction is subject to limitation.  This “tax shelter” test is applied each year, which means that in profitable years, the limit may not apply, but in loss years it will.  Consider buying out limited investor interest that exceeds 35% to avoid this trap.

Electing Real Property Trade or Business

If a taxpayer does business in the real estate industry and elects to depreciate real property under the Alternative Depreciation System (ADS), that taxpayer will not be subject to the limitation.  ADS provides for a slower recovery period than usual and doesn’t allow the instant cost recovery of bonus depreciation. If you are willing to decrease your annual depreciation deductions, you can get out of this limitation regardless of the other factors.

The ADS election may seem an obvious choice, but benefit and cost must be weighed before making a decision.  The election is irrevocable; long-term consequences must be considered.  Also, an entity that may be subject to the 30% limitation might have enough adjusted income to absorb all interest expense, nullifying the benefit of the election.  In addition, losing the benefit of bonus depreciation can be a significant drawback.

All businesses need to understand the consequences of the new interest deduction limitation, but real estate businesses have an extra option to reduce their tax liability.  Shifting debt to equity, buying out limited investors, and (for real estate businesses) making the ADS election are viable options to counterbalance the new limitation.