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.