By Mark Sloan, CPA
Director of CFO Consulting Partners
There has been much discussion regarding Qualified Opportunity Zones (“QOZ”), the tax benefits of investing in a QOZ and how it should fit into a strategy of minimizing taxes on long term capital gains. This newsletter will provide an overview as to the rules governing QOZ and some practical considerations regarding investing in QOZ.
As a result of the Tax Cut and Jobs Act (“TCJA”) passed in late 2017, a taxpayer may elect to recognize certain tax deferrals and exclusions on the gain realized from the sale or exchange of property to an unrelated party if the gain is reinvested in a qualified opportunity zone fund within 180 days from the date of the sale or exchange and the gain remains invested for a defined period of time.
Opportunity zones are eligible low-income census tracts that had either poverty rates of at least 20 percent or median family incomes no greater than 80 percent of their surrounding area’s, according to the U.S. Census Bureau’s 2011-2015 American Community Survey. Such tracts have been nominated by governors and certified by the U.S. Department of Treasury for designation as an Opportunity Zone. There are over 8,700 such tracts located throughout the United States.
A qualified opportunity fund (“QOF”) is the vehicle to which gains must be invested in order to qualify for the tax benefits of the program. In order to achieve the tax benefits, the taxpayer must invest in a QOF and not directly into qualified opportunity zone property. A QOF is a corporation or partnership organized with the specific purpose of investing in opportunity zone assets. The entity must invest at least 90% of its assets in qualified opportunity zone property.
Qualified opportunity zone property can be in the form of direct ownership of business property, or into opportunity zone portfolio companies through either stock ownership or partnership interest. Certain businesses are precluded for consideration as property to be held by opportunity zone portfolio companies and these include golf courses, country clubs, massage parlors, tanning salons, hot tub facilities, racetracks, casinos or any other gambling establishment and liquor stores. These limitations do not apply when a QOF is investing into the Qualified Opportunity Zone directly.
Upon the investment of qualified gains, the basis in the capital gains will be zero. The gain will then be recognized into income on the earliest of the disposition of the opportunity zone property or December 31, 2026. If the QOF is held five years, then the basis is increased by 10% of the original gain and then it is increased another 5% if held for another two years. If the QOF is held at least ten years, then all gains attributable to the appreciation on the original gain will be excluded from income.
There are numerous tax benefits attributable to the timely investment of capital gains into a QOF.
- Deferral of tax on invested capital gains until December 31, 2026, at the latest;
- Permanent exclusion of tax on capital gains of up to 15% if held for seven years, and;
- Permanent exclusion of tax on any subsequent appreciation on the invested capital gains if held for more than ten years.
There are other advantages to investing in a QOF that make it a more flexible option to Section 1031 as a means to shelter capital gains:
- As opposed to Section 1031, which requires the investment of the full proceeds in order to qualify for temporary tax deferral on gains, only the gain portion of the proceeds needs to be invested, freeing up cash at the time of the original sale of capital assets.
- Investment in a QOF can provide permanent exclusion of tax on a portion of capital gains; Section 1031 transactions will only provide for deferral of tax on capital gains.
- As opposed to Section 1031, which requires the investment of proceeds into like kind assets, the only requirement for QOF is that the gains are invested into opportunity zone assets. For example, if a work of art is sold at a gain, then the gain can be invested in a different class of asset such as real estate.
- It should be noted that as a result of the TCJA, the use of Section 1031 is now limited to real estate assets and no longer other types of capital assets.
While there are significant benefits to investing in opportunity zone funds, there are certain caveats that need to be considered:
- If the investment has not been disposed of sooner, the invested gain will be recognized in income at December 31, 2026. This means that the taxpayer will need to provide liquidity for this event while the gain is still locked up in the investment.
- To achieve the 15% permanent exclusion on the original gain, there must be a rollover of the gain no later than December 31, 2019 in order to achieve the 7 year holding period for this exclusion.
- To maximize the tax benefits attributable to this program, the strategy is to lock up the invested gains for a period of ten years. This could result in a lower IRR over the life of the project.
- Although the census data used to designate tracts as opportunity zones is dated and there may be some areas that have gone through improvement, there can still be a higher risk attributable to investing in areas that are opportunity zones.
- An investor may not contribute appreciated property directly into the opportunity zone fund. Such property must be first sold (and begin the clock running for the recognition of a portion of the gain) and the amount attributable to the gain invested into the fund.
- The regulations impose limitations on the amount of cash and intangible assets that can be held at any time by an opportunity zone fund. This limitation can be mitigated through a structure where the QOF invests into an opportunity zone portfolio company (either through stock ownership or partnership interest). Under this structure, the portfolio company can hold intangible assets that are used in an active trade or business and cash in an amount for reasonable working capital needs.
- The investment in opportunity zone funds should be evaluated on the overall economics of the fund and its strategy, and there should not be disproportional weight given to the tax deferral/exclusion feature of the program as the basis for investing in the opportunity zone.
This newsletter is meant as a broad overview on Qualified Opportunity Zones. There are many other details concerning the structure of funds, limitations on the type of assets that can be held by a QOF fund, determination of original use and subsequent improvements, etc. CFO Consulting Partners has been following developments in this area and we stand ready to provide you with guidance in navigating through this new and challenging area. In addition to helping you understand the details and advising you if this program can fit into your investment strategy, we also have relationships with various sponsors and service providers who can offer you opportunities with various funds that they have established. We also have relationships with law firms who can evaluate that the funds are structured in accordance with Treasury regulations.