by Billy Litz
When the Qualified Opportunity Zone Funds (QOZF) were created by the Tax Cuts and Jobs Act (TCJA) in December 2017, there wasn’t a lot of clarity, but there certainly was a lot of excitement. The idea behind this program was to tap into the trillions of dollars of unrealized capital gains from various investments by incentivizing taxpayers to develop certain areas throughout the United States. Recently, the IRS released proposed regulations that offered advisors and investors more clarity, and thus more interest, in this tax incentive program. Here is what you need to know:
What are the tax incentives you mention?
Well, for taxpayers with capital gains you will be able to defer the tax liability on the capital gain until 2026 (or sooner if you sell your ownership in the fund before then) by investing in a QOZF. The gain deferred is equal to the investment in the QOZF. There are also benefits for maintaining your ownership for certain milestones. If an investor holds the QOZF investment for at least 5 years, then the basis in that investment is increased by 10% of the amount of the gain originally deferred. If the investment is held for at least 7 years, there is an additional 5% increase in basis for a total of 15%.
In addition to the reduction of the taxable gain, there is an added incentive for investors who hold their investments for more than 10 years. If the investment is held for more than 10 years, the taxpayer’s basis of the investment can be stepped up to the fair market value on the date of disposal. This would make the appreciation on the investment over the 10+ year period tax free. We don’t get to use those words often, so I will repeat that. Tax free!
You should note that in order to qualify for the 7 year milestone, which comes with the full 15% basis increase, you will need to make your investment in a QOZF by December 31, 2019.
That sounds great, but what is an Opportunity Zone Fund?
QOZFs can be setup as either a corporation or partnership and will be required to hold at least 90% of their assets in Qualified Opportunity Zone Property (QOZP). QOZP can be broken down into 3 parts: Partnership interest, Stock or Business property. For purposes of this article, I will focus on business property, specifically real estate.
To qualify as QOZP, the real estate property must be located within an opportunity zone (OZ) (a map of the zones can be found here). Also, the original use of the property must start with the QOZF or the QOZF must substantially improve the property. For real estate, this means that if you are purchasing land and building within the OZ this would not qualify as the original use of the property and the QOZF would be required to substantially improve the property. Substantial improvement was an issue that advisors and investors were looking for clarification from the IRS on, thankfully the proposed regulations addressed this issue and confirmed that only the building would need to be substantially improved in order to be QOZP. Substantial improvement is defined as an improvement made within 30 months of the purchase with a cost greater than or equal to the purchase price. This is best illustrated by an example:
A QOZF purchases land and building within an opportunity zone for $1 million. The portion of the purchase price related to the land was $400,000 and the portion related to the building was $600,000. The QOZF would need to make at least $600,000 of improvements within 30 months for the property to be considered QOZP.
Depending on how you would like to structure the deal, the real property located within an opportunity zone could be held within an LLC and the QOZF could purchase the LLC interest instead of directly holding the real estate.
Now that I know what an Opportunity Zone Fund is, how can I invest in one?
Step one is you need to have a transaction that creates a capital gain. Capital gains come in many forms and from many sources. Luckily, there is a lot of flexibility in how you can make an investment into a QOZF, including at both the entity and individual investor level. The proposed regulations provide that a pass-through entity may elect to defer a gain by making an investment in a QOZF, and the deferred gain would not be included in the distributive share of the owner. If any capital gain is included in the distributive share of an owner, then the owner can make their own election to defer the gain.
In order to qualify for the tax deferral, the investment in a QOZF must occur within 180 days from the date the taxpayer is required to recognize the gain. For individuals and partnerships/corporations, that would mean the date of the transaction. In the case that a capital gain is included in the distributive share of an owner of a pass-through entity (via a K-1), the owner has the option for their 180 day window to begin on the date of the sale that created the gain or on the last date of the tax year for the pass-through entity. This will open up the opportunity (pun intended) for a pass-through entity investor with a capital gain from a sale in early 2018 (ie: 180 days has passed already) to make an investment in a QOZF in order to defer their gain.
Going forward, in an effort to make their opportunity zones more attractive than others, states and local jurisdictions may offer up additional incentives. Governor Hogan has already announced that Maryland plans on spending $56 million on various incentives for zones within Maryland.
With the clarity provided by the proposed regulations, more Opportunity Zone deals are going to start to appear. Please be sure to discuss any investments you are considering with your tax advisor. While the tax incentives can be very beneficial, you need to make sure that all of the requirements are met…and there are many. If you have any questions, feel free to reach out to your team at Snyder Cohn.