The Tax Cuts and Jobs Act of 2017 created an avenue for taxpayers to temporarily defer capital gains, potentially exclude up to 15% of those same deferred gains, and permanently exclude post-acquisition gains from the sale of a qualified opportunity fund (QOF) investment. This can be achieved by investing capital gains in a fund that has elected to be a QOF located within one of the nearly 9,000 “qualified opportunity zones” (QOZ) set out by Section 1400Z-1. These QOZs are intended to promote growth and long-term investment in certain low-income communities. The proposed regulations published on October 19, 2018, and on April 17, 2019, provide guidance for understanding how to achieve gain deferral and exclusion, spells out detailed requirements of QOFs, and divulge other information taxpayers need to correctly implement opportunity zone projects.
Section 1400Z-2 details the process, including definitions, timeframes, and tests that must be passed in order to receive the tax benefits. A very general example is as follows:
- A taxpayer realizes any gain characterized as capital gain
- The taxpayer reinvests the gain within 180 days into a QOF and defers the gain in the year of sale
- The QOF conducts a trade or business, either directly by holding qualified opportunity zone business property (QOZBP) or indirectly, by holding QOZ stock or a QOZ partnership interest
- After holding the interest in the QOF for five years, the taxpayer permanently excludes 10% of the original deferred gain by increasing the basis in the gain by 10%
- After an additional two years, another 5% of the original deferred gain is excluded
- Any remaining original deferred gain is recognized on Dec. 31, 2026, unless an “inclusion event” occurs prior to that date
- After holding the interest in the QOF for a total of ten years, the taxpayer may sell the investment in the QOF – or, in limited circumstances – the QOF may sell its assets – any time before 2048 and the taxpayer excludes the gain resulting from the sale.
Qualified Opportunity Zone (QOZ)
Generally, an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. QOZs are an economic development tool – that is, they are designed to spur economic development and job creation in distressed communities. Governors in each state selected QOZs from an eligible group of low-income census tracts.
Qualified Opportunity Fund (QOF)
An investment vehicle that is set up as either a partnership, a corporation or a limited liability company for investing in eligible property that is located in a QOZ and that utilizes the investor’s gains from a prior investment for funding the QOF. The fund must invest in QOZP. The funds are required to invest at least 90% of their assets in designated QOZs. The qualified assets can be real estate, local businesses or other business assets located in a QOZ, issuing stock, partnership interests or business property to their investors. The funds themselves certify that their investments align with the law. In order for the fund to self-certify, a QOF will complete Form 8996, Qualified Opportunity Fund, with its tax return for each year the entity intends to operate as a QOF.
Qualified Opportunity Zone Business (QOZB)
A trade or business in which at least 70% of the tangible property owned or leased by the taxpayer is QOZBP. Many restrictions that allow tangible property to be classified as QOZBP. The business cannot be 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 where the principal business of which is the sale of alcoholic beverages for consumption off-premises. It must also meet the following tests:
- At least 50% of the gross income must be derived from the active conduct of a trade or business in the QOZ (the “50%-of-income test”);
- A substantial portion of the intangible property must be used in the active conduct of a trade or business in the QOZ (the “intangible test”); and
- Less than 5% of the aggregate unadjusted bases of the property of the trade or business is attributable to nonqualified financial property (the “5%-of-assets test”).
Taxpayers Eligible to Defer Gain
Taxpayers eligible to elect deferral under Section 1400Z-2 are those that recognize capital gain for federal income tax purposes. These taxpayers include individuals, C corporations, partnerships, S corporations, trusts, and estates. Special rules exist for partnerships and other pass-through entities, which can elect gain deferral at the entity level, or choose to pass-through the gain and let the owners decide on making the election.
One of the great benefits of Section 1400Z-2 is the ability for a taxpayer to take cash off the table from the sale or exchange that results in a capital gain. In order to fully defer the gain, the taxpayer does not need to reinvest the total cash they received, only the amount that would be recognized as gain. This is different from a Section 1031 (like-kind) exchange where any proceeds not reinvested and taken by the taxpayer is taxable as boot received. For example, the net proceeds received from the sale of stock was 1 million dollars, resulting in a $250,000 capital gain. The taxpayer can take $750,000 to use freely, and reinvest only the $250,000 in a QOF to defer the gain.
The QOF investment taxpayers utilize should be treated as any other investment, knowing the risks involved. A non-exhaustive list of risks investing in a QOF include:
- Potential slow cash flow yield during the first few years of development or improvement
- Traditional real estate risks, such as market conditions, tenants, and vacancies
- The QOZ Program is new, and final regulations which are yet to be issued which could negatively impact taxpayers strategy
- Complexity in the rules to qualify as a QOF and QOZB, depending on the type of investment
- Due to the attractiveness of the tax benefits, there could be a surplus of real estate in a small area without the equivalent demand
- Lackadaisical due diligence in order to comply with improvements requirement if the original use of QOZBP in the QOZ did not commence with the QOF
- Term of investment required (10 years for full exclusion of post-acquisition gains from the sale of the QOF)
- Tracking issues for tax purposes given the time periods required for this benefit
- Investments in QOZ are low income, the rate of return could vary vastly
Investors should also be aware that there are penalties if the fund fails to meet the 90% threshold of assets invested in QOZs. The percentage of assets is measured “on the last day of the first six-month period of the taxable year of the fund, and on the last day of the taxable year of the fund.” If a fund fails to meet the 90% standard, it is subject to a penalty for each month it fails to meet the required threshold. The penalty is “(i) the amount equal to 90% of its aggregate assets, over (ii) the aggregate amount of QOZP held by the fund, multiplied by the underpayment rate established under Code Section 6621(a)(2)” for each month the fund fails to meet the required threshold. Section 1400Z-2(f)(1).
We Can Help
The QOZ Program is unprecedented as taxpayers have likely never seen a more lucrative opportunity to temporarily defer capital gains, with the potential to permanently exclude gains from the sale of a QOF investment. There are strict deadlines, complex rules, and various reporting requirements to successfully achieve this, but if done correctly, this program could save some a great deal of tax. With that being said, this program is not for everyone and should be planned and analyzed thoroughly before investments are made. Contact your local Blue & Co. advisor to discuss if this is the right option for you.