How Real Estate Investors Can benefit from Qualified Opportunities Zones
How Real Estate Investors Can benefit from Qualified Opportunities Zones
One of the real estate tax shelters created under the Trump tax reform is the tax deferral and reduced tax rate by investing on the program Qualified Opportunities Zones (QOZ), also enacted under the same tax reform. QOZ were created to encourage long-term investment in low-income urban and rural communities to re-invest their unrealized capital gains into Opportunity Funds that are dedicated to investing in QOZ designated by the Governor of each U.S. state and approved by the The U.S. Treasury. According to The New York Times, there are 8,800 approved QOZ in the U.S.
A Qualified Opportunity Fund (QOF) is an investment vehicle that is set up as either a partnership, an LLC or corporation for investing at least 90% of its assets in eligible property that is located in a QOZ. If you are interested in forming a QOF, there is a list of designated zones, click here for the designated zones list that the fund must invest in, in order to qualify for the tax shelter. The same list applies for investors willing to buy an interest in the fund and benefit from the tax shelter. Click here for more QOZ resources.
To become a QOF you just need to invest in a QOZ and elect QOF classification with the IRS by filing form 8996 at the filing of the return detailing the assets invested in the QOZ.
Amazon is one of the first tech beneficiaries of investing in a QOZ in NY, after the announcement that one of its two headquarters will be located in Long Island City.
The potential of capital investment is $6 Trillion according to Barron’s. The mechanics for an investor is very simple:
- You have a current investment in the stock or real estate market and sell it. You don’t have to pay taxes on the capital gain if within 180 days (similar to a 1031 exchange) you invest into a QOF. After 7 years if the interest in the QOF is sold, you will pay capital gain tax on 85% of the original capital gain only, meaning 15% of the original capital gain will be excluded from taxes.
- In addition, there is a permanent exclusion from capital gain tax from the sale or exchange of an investment in a QOF if the investment is held for at least 10 years. This exclusion only applies to gains accrued after an investment in an Opportunity Fund.
- Original: $1M capital gain from the sale of an asset
- Investment: QOF
- After 7 years: capital gain tax payable on 85% of the original $1M capital gain (1)
- After 10 years: any capital gain created from the QOF investment is completely tax free.
There are very specific requirements for QOF to getting the tax benefit:
- All of the property must be within the QOZ during the holding period.
- QOF businesses must derive 50% of its gross income from active business in a QOZ.
- Within 30 months the QOF provides substantial investments equal to the purchase basis of the building (land is irrelevant) to qualify as a QOF.
There are exceptions to QOF investments:
- Any sin business is not acceptable
- Country club or golf course, not acceptable
- Liquor store, not acceptable
- Massage parlor, not acceptable
- Racetrack or any gambling venue, not acceptable
- Hot tubs or tanning, not acceptable
Investors willing to form QOFs need also become certified with the IRS at the filing of QOF tax return. QOFs, as mentioned above, can be organized as and LLC or as a Corporation.
For 2018, taxpayers who invested in QOFs (to benefit from the tax shelter) need to elect the gain deferral when filing their tax return in 2019.
For those taxpayers who invested in QOFs in 2017 and want to take advantage of the tax deferral, you can file an amended tax return and claim a reimbursement.
IRS Opportunity Zone Clarifications
Although the Opportunity Zone Program was introduced without much fanfare along with the Tax Cut and Jobs Act, it has sent waves through the world of real estate, municipal development, and financial advisory.
In the meantime, more than 8,700 qualified opportunity zones and hundreds of qualified opportunity funds have been created to pull in investment dollars for economically challenged areas. Of course, the altruism of investors is rewarded by generous tax deferrals & exemptions on capital gains.
Despite this, billions of dollars have been waiting patiently on the sidelines, until Tranche II (new proposed opportunity zone regulations) are published.
Upon publication, tranche II did not disappoint. It clarified many of the issues investors anticipated.
Capital Contributions, Equity Interest And Disposition
- The new regulations make it clear that investors can make capital contributions other than cash to a Qualified Opportunity Fund. The qualified investment in such a case would be the lesser of the tax basis in the property contributed or the fair market value of the equity interest in the Qualified Opportunity Fund. Liabilities on the asset added will reduce the qualified investment, and the tax basis of the asset contributed.
- Quality Opportunity Fund investors that provide services and receive compensation in equity interest, and investors who receive a Qualified Opportunity Fund interest in exchange for appreciated assets, will create a mixed fund.
- These investors will not be eligible for Opportunity Zone benefits for the full value of the appreciation in the contributed property or Qualified Opportunity Fund value received as remuneration for services rendered.
- Any disposition of an interest in a Qualified Opportunity Fund by a holder of equity will be considered an inclusion event that will immediately trigger tax on unrecognized deferred gains.
- However, distribution of the qualifying investment to a beneficiary by an operation of the law/estate, will not be considered an inclusion event.
- Any donation of an interest in a Qualified Opportunity Fund to a charity will be seen as a termination of the donor’s investment in the Qualified Opportunity Fund.
- This will then trigger tax on the deferred gain to the donor.
- However, when treated as a gift to a grantor trust, it will be deemed not to be a Qualified Opportunity Fund interest termination, and hence, no gain will be triggered.
- Because of the Qualified Opportunity Fund basis step-up, no depreciation recapture will be reportable upon exiting from a Qualified Opportunity Fund, after ten years.
- Were the Qualified Opportunity Fund or Qualified Opportunity Zone business to generate ordinary income by selling depreciated personal property, not the code nor regulations exempt the gain from taxability.
- However, the disposition of a Qualified Opportunity Zone interest held for more than ten years, will exempt the depreciation recapture.
Improvement and Original Use Defined
- The regulations make it clear that raw land does not have to be improved substantially (=100% of original basis within 30 months)
- When it comes to the substantial use requirement for used tangible personal assets (non-real estate), the regulations make it clear that the substantial improvement test must be applied asset-by-asset and not on an aggregate basis.
- Treasury and the IRS concur that if a building has been vacant for more than five consecutive years before a Qualified Opportunity Fund or Qualified Opportunity Zone Business purchased it, the original use requirement will be met without any further substantial improvements.
- Leased assets are treated as original use by the lessee and treated as purchased property. For real and personal property, no substantial improvement is required.
Partnership and Basis Treatment
- Partner or member tax basis in a Qualified Opportunity Fund is zero at the point of initial investment since the gain is being deferred. The basis increases along with the partner’s share of liabilities.
- A transfer in a Section 721 transaction is not an inclusion event.
- Some partnership distributions may be considered inclusion events. Cash-out-refinances for Qualified Opportunity Finds will, as a rule, be allowed.
- The original Qualified opportunity Zone investor can sell his equity interest, and the new investor can step right into his shoes, but the 10-year holding period for the new investor starts fresh.
- Also, the new investor will have to roll a qualifying capital gain into the repurchase before deriving the five-, seven-and 10-year benefits.
- The deferred gain to be recognized in 2026 will be taxed at 2026 rates for capital gains and not the rate of the year the first sale took place.
Qualifying Business Within The OZ
- Fifty percent of the gross receipts of a Qualified Opportunity Zone Business must derive from an active business within the Qualified Opportunity Zone.
- Alternatively, based upon the compensation paid by the Qualified Opportunity Zone Business to employees, at least 50% of the salary must be paid for services performed within the Qualified Opportunity Zone.
- Alternatively, based on the hours worked by the employees, at least 50% of the hours must be accomplished inside the Qualified Opportunity Zone.
- Alternatively, the tangible property located within the Qualified opportunity Zone Business must constitute at least 50% or more of the entire property within the Qualified Opportunity Zone.
- In unique situations, a fallback into a “facts and circumstances provision” is provided.
- The Qualified Opportunity Fund can elect a semi-annual qualification test without considering investments received in the preceding six months. This essentially provides the Qualified Opportunity Fund with 12 months to reinvest in a Qualified Opportunity Fund Business or Property.
“Substantially All” Clarified
- The threshold is 70% for the use in an Opportunity Zone threshold. For intangible use, the test is 40%.
- The threshold is also 70% for the tangible property “owned or leased,” which has to be qualified Opportunity Zone property for a business to be a Qualified Opportunity Zone Business.
- The threshold is 90% when measuring a Qualified Opportunity Fund holding period of tangible property as Qualified Opportunity Zone business property, Qualified Opportunity Zone partnership or corporation.
- The regulations clarify that GAAP valuations or another method may be used for leased asset qualification testing.
- It has been clarified that as long as the Qualified Opportunity Zone follow specific management rules, residential rental activities can qualify as a Qualified Opportunity Zone Business and/or Qualified Opportunity Property, but a Qualified Opportunity Fund that enters into a single triple-net-lease with respect to real or personal property, will not qualify as an active trade or business.
- The original use of tangible property purchased starts on the date the person first placed it in service in the Qualified Opportunity Zone for purposes of depreciation or amortization.
- Documented working capital can be treated as Qualified opportunity Zone property for a term of up to 31-months (in respect of 90% and 70% semi-annual testing).
- Net Section 1231 losses are treated as ordinary losses.
- Net Section 1231 gains are treated as ordinary capital gains.
- The 180-day clock starts “ticking” at the year-end.
- If the Qualified Opportunity Fund sells Qualified Opportunity Zone property shortly before the 90% testing date, it is provided enough time to reinvest the proceeds back into the Qualified Opportunity Zone. Reasonable time/enough time is defined as 12 months, invested in cash or debt instruments with maturities of less than 18 months. The reinvestment has no impact on the reporting of the tax gain triggered on the sale.
What Remains To Be Clarified After Tranche II?
- More robust reporting requirements would improve the evaluation of Opportunity Zone benefits by federal, state, and local government agencies.
- The new regulations contain no reporting requirements to allow the IRS, HUD, and the public to determine taxpayer compliance with the new rules.
- The IRS & Treasury acknowledge that despite the burden brought about by more reporting requirements, to address the concerns, comments are invited for the next set of regulations.
Tranche II answered many questions and will provide taxpayers and investors enough comfort to move forward with Opportunity Zone investment. More questions remain, however. Treasury will continue to issue guidance, so watch this space.
Reinvestment Requirements In Opportunity Zones In 180 Days
If you wish to utilize the substantial benefits of the OZ program, meeting the initial investment deadlines is vital. Timing is everything.
Opportunity Zones (OZ) offers qualifying taxpayers with capital gains income an opportunity to eliminate a portion and defer a large part of their federal gain and possible also, their state gain.
The Nine Percent Rule
The 90 percent average is determined by the average of the percentage of qualified opportunity zone property held in the fund measured on the last day of the first six month period of the taxable year of the fund and the last day of the taxable year of the fund.
Must Be Equity Interest
In terms of proposed regulations, the investment in a QOF must be equity interest into a C Corp (including regulated investment companies and real estate investment trusts) or S Corp stock, a partnership, or other pass-through entity. It can include preferred stock and partnership interests with special allocations.
The equity can be used for collateral for a loan. Investments made in convertible debt or amounts treated as debt under IRC Section 1275(a)(1) and Treasury Regulation 1.1275(d) do not qualify for QOZ deferral.
180 Days Reinvestment Period
A QOF must be established within a 180-day window a and the day of the sale or the recognition thereof falls within this period. It is specifically stated in the statute that we are dealing with 180-calender days and not six months. The required concentration on counting accurately must be handled with precautious: make your investment well-before the 180-days deadline to be safe.
The First Day
Described in IRC Section 1400Z-2(a)(1)(A), the first day of the period begins the day the deferred gain is recognized for federal tax purposes, disregarding the OZ deferral election until 2026. Installment sale structuring and like-kind exchanges can provide more time for investors who wish to postpone the beginning of the 180-day countdown. Keep in mind, however, that if you defer gains too far forward, you might not be able to generate a qualified capital gain before the termination of the investment phase of the OZ program on December 31st 2026.
Partnership And LLC Members
Partnerships and other pass-through entities can defer gains at the partnership level, and this means the 180-days countdown is postponed as well. If the partnership does not make the selection, the individual partners can still elect to make an OZ reinvestment.
Moreover, partners and LLC members get additional time to make their choice since they are not considered to have recognized capital gains before the last day of their tax year, which is not before December 31st for most calendar-year entities.
The option remains available to taxpayers to recognize the gain on the same day as the asset sale happened and to have the 180-day countdown start on the same to accelerate the investment window.
Those who defer gains into a QOF and invest their entire interest into a QOF can make further QZ deferrals into another QOF within 180-days.
How To Defer Capital Gain Deferral
Taxpayers need to attach IRS Form 8949 to their tax return, which would have reported the qualifying gain for the year of the deferral.
With many deferral elections, the capital gain can be divided into different QOFs. It is recommended that you use a different QOF for every underlying investment.
Opportunity Zone Investors Will Benefit From Learning These IRS Regulations
After two years, the final regulations about the opportunity zone program has just been released to the public. The document is 544 pages long and adds a number of new details. The Secretary of Treasury said that the new regulations will provide clarity and certainty and will cause more money to flow unto opportunity zones.
Some of the issues addressed:
- Rules around aggregation of developments on one property, to meet the substantial improvement requirement.
- What happens to investments pulled out of opportunity zone funds before the ten-year holding period is done?
- Qualified Opportunity Zone businesses (QOB)
- The 5% maximum investment in “sin businesses” that would otherwise be disqualified from the tax break.
- IRS and Treasury allowed for QOF to be structured like most funds that invest in multiple businesses or properties. It removed language in the previous regulations that required all of the QOF to be sold at once to qualify for the maximum capital gains tax discount
- Now QOF can sell individual properties. It is no longer required to sell the entire QOF, including the LLCs, a QOF creates to hold the properties.
- Now QOFs can hold multiple property LLCs and various assets within them, and it can exit those assets without taxable events or losing OZ benefits.
- The final regulations allow the improvement threshold to apply to properties in aggregate – additional buildings and developments can be considered to add value to the lot itself.
- Now you can add a new multifamily building to a property that contains a multifamily building, and write it off as a substantial improvement.
The question of QOBs remains under-explained. In the raw, the law states that any capital gains realized from QOBs after a holding period of ten-years are exempt from taxes. Uncertainty has capped investment in QOFs at under $5 billion.
Experts report that the new regulations will open the floodgates for enormous investment. People will spend some time to digest the new rules, but it will result in a positive inflow into OZ.
The late date of the publication will not lead to increased investments before December 31st, 2019, the deadline for the 15% maximum discount after a ten-year hold.
One issue relates to Form 8996, which requires disclosure of all of the investments of the QOF, the census tract in which the assets are located, and the value of the assets as measured at certain times of the year. When an investor sells, Form 8996 requires disclosure of his name, the value of the investment, and the percentage of the fund that the investment represented.
IRS cannot require information in respect of the impact of the investment, such as:
- Number of jobs created
- Change of income levels
- Change of Demographics
- Indications of gentrification
The original sponsors of the bill introduced legislation in November to require the reporting of the same, but some members of Congress apparently introduced bills that go a lot deeper and further. It would disqualify some zones on the grounds of so-called affluence, while some zones targeted are allegedly linked to friends and family members of key figures on the program. No proof of these allegations was provided.
How To Use Real Estate Opportunity Zone Investments For Tax Deferral
Deferred tax isn’t what it used to be! The years and years of low-interest rates changed many minds about deferred taxes. Mind you, deferring large once in a lifetime capital gains tax, will still get the blood flowing.
Opportunity Zones Are All The Rage
At the moment, Opportunity Zones are all the rage. If you invest in an opportunity zone, you are allowed to defer the capital gain. On the one hand, there are some distinct advantages of doing it this way. You have to invest the gain, but you are free to do with the proceeds as you wish. Also, by holding on to the gain long enough, you can reduce the amount realized.
However, none of these opportunity zone funds have track records, and they are attracting very substantial amounts of money. Paying your taxes instead of going this route might be the wiser option.
Three Techniques We Like
If you sell an upmarket residence, some commercial real estate or a business and you are in for some substantial capital gains, there are some new techniques available to keep you in financial assets or that will make it possible for you to do with the proceeds whatever you want.
If we assume that you have a large cash offer for your property, and that is not interested in the property remaining in your name, and assuming that ordinary income recapture is negligible, your default option, option A is to collect a percentage of the sales price of the property in cash. The amount of money will be decided by:
- Your adjusted basis
- Unrecaptured Section 1250 depreciation
- Applicability of NII
- State Income Taxes
For the sake of argument, say the cash is 80% of a $5 million deal. That leaves you with $4 million to use however you please.
Keep In Mind
Stretching the capital gain over a few years can lead to lower taxes for you. For valid projections, it is advisable to consult a tax professional. Keep state income tax, thresholds, phase-out’s and net investment income tax in mind when you make your projections.
Deferred Sales Trust (DST)
Much hype surrounds the so-called DTSs. If you stand back from the secretive sales pitches and the non-disclosure agreements that surround the DSTs it boils down to this — you sell your asset to a special purpose entity that sells it to your buyer. What you get from the entity, is an installment notice based on your risk tolerance.
Put differently; you get an obligation secured by a portfolio that is managed to provide you with a return, let’s assume, of 5%. Re-negotiations are possible within reason; i.e., the term of the note can be extended.
The opposing party gets to manage assets. Your net returns are turned over to your asset manager, for which you pay 1% or less. In this scenario, a DST is a terrific deal. The money that you would have spent on capital gains tax is now also working for you.
NDAs shroud the intricacies of the DST, but looking at it from the outside DSTs would probably survive IRS scrutiny.
Structured Installment Sales
Structured installment sales are straightforward. You sign an installment sale agreement with your buyer. The buyer, in turn, pays a financial institution to assume the obligation to perform on the note on his behalf.
Trust companies offer this service, and it is rumored that one major insurance company plans to enter the market soon.
What you gain is smoothed out capital gains recognition. If this saves you much tax, and you are willing to live on relatively low returns, this is the one for you.
If you use a robust institutional intermediary, execution will be compliant and done well, and you end up with minimal risk.
Monetized Installment Sale (MIS)
Whenever you use an installment obligation as collateral, gain recognition is triggered. The MIS seems to avoid this, and leaves most of the proceeds in your hands to do with as you please, while still deferring the gain.
The IRS Chief Counsel Office advisory letter 20123401F supports this view in a somewhat equivocal manner. The letter merely states that a transaction like this should not be attacked with “substance over form” or “step transaction.” The letter only says what the view of the IRS towards the transaction is not. Several public companies disclosed the transaction in their SEC filings, which adds some “credibility” to it.
Here Is What You Do:
You sell your property to your dealer for a thirty-year interest-only installment note. In turn, the dealer sells the property for cash, which goes into escrow. Subsequently, you borrow money on a non-recourse basis from a third party lender protected by the escrow agreement.
In theory, the seller’s interest payments are tax-deductible while the interest payments the seller receives are taxable as income, and the two are supposed to wash.
All this will, of course, depend. How did you spend the money? Did you spend it on personal items? If so, it will not be deductible. However, there are many ways in which interest deductions can be suspended for federal purposes.
Will It Work?
On the one hand, if the transaction is executed congruent to the Chief Counsel Letter, it should work. On the other hand, problems exist.
- The arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation.
- The intermediary’s obligation to the seller is not formally “secured” by cash or equivalents.
However, the MIS arrangement (described above) is substantially the same as one or both of the gain-recognition-triggering events. Arrangements that have a similar effect should be treated the same. Only the IRS can clarify this uncertainty.
In the meantime, the IRS is attempting to assess promotor penalties on at least one MIS promotor. MIS then is not for the faint-hearted. If you want absolute certainty in life, pay your full tax bill and only then spend your remaining proceeds your way.
Check Our Tax Planning for U.S. Real Estate Investors To Start Your Tax Strategy
Benefit From Opportunity Zone Investing
When party-goers dance into the new year on December 31st, 2019, investors with capital gains will be dancing to a different tune: they will be rushing to make investments in qualified opportunity funds (QOF) to get the ‘full’ benefit from the program.
The program will still be open for new investors after January 1st – see below for the details. Take care of your due diligence. It is more important than rushing to meet an incentive deadline and possibly ending up with a hasty investment. Investors have two years left to invest in a QOF.
AFTER JANUARY THE 1ST THE CREDIT FOR DEFERRED CAPITAL GAINS FOR QOF INVESTMENTS HELD FOR SEVEN YEARS GOES DOWN FROM 15% TO 10%
By rolling capital gains into a QOF, you incur lots of benefits: The trade-off lies between a few percentage points in tax savings and taking your time to find the perfect fund, project and zone. The act provides the opportunity to benefit from substantial tax savings if you invest in opportunity zone funds, but it also makes it possible to invest in, and operate businesses located in more than 8,700 qualified opportunity zones across 50 states.
- You are free from capital gains taxes on your money until 2026
- When you become liable for capital gains taxes in 2026, the rate goes down by 15% (or 10% of you invested after January the 1st)
- If the fund holds the asset, you invested in for a minimum of ten years, you will qualify for a zero-rate in capital gains when that asset is sold pone day.
In fact, opportunity zones allow investors to put the government’s dollars to work by helping entrepreneurs and job creators to make their dreams come true.
If you own appreciated assets in the form of stocks, art, a residence or a business – albeit as an individual owner, C corporation, partnership, S corporation or trust, and if you are interested in making a long-term investment, or starting an enterprise, then this is for you.
These are the front-end benefits:
- Defer your capital gains tax until 2026
- Reduce the rate of capital gains tax you eventually pay after 2026 if you invested before January the 1st 2020, by 15%.
On the back-end:
- You will acquire an asset that will most likely increase in value.
- If you hold that investment asset for ten years or longer, you will pay ZERO TAX on the sale of the asset.
California, North Carolina and Mississippi do not follow federal guidelines on opportunity zone investing!
Ready For Opportunity Zone Investing?
|Lower your tax bills||Commit to a long-term investment of ten years or longer|
|Help disadvantaged areas||Give up some control over your money|
|Defer and save taxes||Some opportunity zones are in very low-income areas|
|Opportunity zones are not found only in low-income areas|
Investment Choice For Opportunity Zone Investors
|Invest In Real Estate Asset||Invest In Operating Business|
|You can invest in a multifamily apartment complex in a designated zone,||It is quite a complicated process|
|Or a ground-up substantial rehab,||It will require sophisticated advice from lawyers and advisors|
|A ground-up commercial development||You have to meet the tests required|
|Or a hotel redevelopment, etc||It is about more than merely locating to an opportunity zone|
|Invest In An Well- Established QOF||Form Your Own Fund||Start A Business In An Opportunity Zone|
|Most investors follow this route||Is the money you have available, enough to start your own fund?||It can bring substantial tax benefits|
|Due diligence of utmost importance||You need a top-tier law firm||Make very sure you satisfy the tests for such a new business|
|Do feasibility study and ongoing review of the fund||You need a top-tier tax advisor||It must locate in a QOZ|
|Who are the general partners that manage the fund?||You need a top-tier advisor||It must derive at least 50% of gross income from an active trade or business inside the OZ|
|Who does the audit on the fund? It has to be a large and well-known firm||New regulations require that at least 50% of the services performed (hours) by employees and independent contractors take place inside the QOZ|
|There are more than 150 Qualified Opportunity Funds by now||New regulations require that at least 50% of the services performed (hours) FOR THE BUSINESS BY ITS employees and independent contractors take place inside the QOZ|
|OR, if the tangible property of the business that is in the QOZ and the management, operational functions performed for the company in the OZ are each necessary to generate 50-percent of the gross income of the trade or business.|
Hidden Gems In The Federal Opportunity Zone Program
The OZ program is already making a p0ositive difference in underserved communities at both local and state levels. There are enormous opportunities for investors with capital gains, but the rules are complex.
The OZ program is sophisticated, but it is flexible filled with significant advantages for those in the know. A lot of the uncertainty over the program was addressed in Treasury’s latest Tranche II set of OZ regulations. It provides guidance for business operators, landlords, and real estate developers. It also elucidated the mechanics, the deadlines and holding periods that caused a lot of confusion.
Partnerships are sometimes very complicated vehicles for investment. The more partners, the more opinions there are on every decision that has to be made, sometimes very divergent views cause rifts, and when the partners decide to split, the sale triggers gains for every partner (i.e. the remaining partners structure a 1031 transaction to roll their gain and equity into a commercial property) and a 1031 ties-up the capital for every partner. In such an event, sophisticated alternatives have to be investigated, such as splitting the property into ‘tenant in common’ interests followed by the liquidation of the partnership before any sale can take place.
Things are very different in the OZ program. Parties are allowed to sell their interests. If the partnership does not select OZ-treatment at the equity level, the gain will flow to the partners on their year-end Form K-1. Partners can choose to take their profit, or under the OZ program, to invest their benefit into a QOF within 180-days. The equity holders are separated, and everyone wins.
S corps are very popular amongst business owners, but there is one significant disadvantage to it. When the company is sold, or one of the owners dies, the ‘inside’tax basis of assets held in the S corp retain their historic cost basis, and therefore a step-up is as a rule, not possible for buyers except if they make a 338(h)(10) election. The OZ program offers a solution for extracting assets stuck inside an S corp to prevent this trapped appreciation.
|Suppose S corp A holds an operating business and owns the building that houses the company.|
|The property has a tax basis of $1 million and a fair market value of $2.5 million.|
|The owners need to replace the current building with a new, state of the art facility.|
|ONE OPTION: The owners can engage a 103q transaction within S corp A.|
|RESULT OF OPTION I: This option offers unlimited deferral of capital gains and allows gain deferral for all states.|
|SECOND OPTION: The owners can sell the property in S corp A and elect OZ treatment at shareholder level for the gain, and by doing this, strip the asset from within S corp A while deferring the gain until 2026.|
|RESULT OF OPTION II: The building is now owned outside S corp A.|
|TAKE NOTE: Under the related-party rule some structuring will be required to succeed in doing this.|
|CONSTRUCTION: If a ground-up construction project is undertaken for the new building, the shareholders can take up to 30-months to deploy the funds.|
Four Year Replacement Window
Taxpayers who sell appreciated real estate are always under pressure. They need a special accommodator to escrow all proceeds from the sale, and they must identify replacement property within 45-days of the date of the sale. This means that the taxpayer must close on the replacement property within 180-days. It has ramifications. The taxpayer is often forced to overpay for the replacement property, or they end up with a property that is less than ideal.
The OZ program, on the other hand, will always give the taxpayer more time to make smart decisions. A taxpayer that reports a real estate gain on Form K-1 has 180-days after the year-end to invest in a qualified opportunity fund, and he will not have to identify the replacement property for years; it can provide real estate investors up to 48-months or more. The extra time makes it possible for the taxpayer to do a ground-up construction to build the ideal replacement property.
Also, OZ transactions only require investors to reinvest their capital gain from the original investment, not the entire proceeds, so they can pocket their original basis and ‘ordinary.’
Take Note: Gains from an OZ program reinvestment will be recognized in 2026 irrespective whether the replacement property is still held.
A 1031 structure for real estate disposition will be advantageous for residents of states that do not recognize the OZ program yet. This includes :
- North Carolina
There are advantages to the way debt is treated in OZ regulations. When a QOF is formed as a partnership, the investor’s share of the mortgage or other liabilities is treated as a capital contribution (basis increase) insofar as the debts of the QOF has obligations that are allocated to the partners.
This basis increase makes it possible for QOF investors to claim the tax losses that flow through the entity. In terms of the clarified regulations, the debt layer is eligible for a full step-up to fair market value in year ten.
|INVESTOR A: Rolls $500,000 into a QOF using the funds to buy raw land. He gets a $2.5 million interest-only loan to build an office building, and he claims $800.000 in depreciation over the next ten years,|
|CALCULATE A’s TAX BASIS|
|TAX BASIS IN QOF:|
|Deferred gain deposited||$0|
|Basis for debt allocated||$2,500,000|
|Basis increase of 10%||In year five||$50,000|
|Basis increase of 5%||In year seven||$25,000|
|Basis increase for 85% gain||In 2026||$425,000|
|Decrease for depreciation||($800,000)|
|QOF TAX BASIS||YEAR TEN||$2,200,000|
As we mentioned above, opportunity zones are by no means only for real estate investors. Businesses (QOZBs) can deploy funds under the working capital safe harbor rules to start, buy or move businesses into an OZ.
If you start a business inside a QOF, IRC Section 1202 (for small business stock or QSBS) provides tax exemptions for the types of companies that meet the various statutory criteria. The QSBS rules allow every taxpayer that is a non-corporate shareholder to exclude the greater of:
- $10 million of cumulative QSBS stock gain, or
- 10× the taxpayer’s tax basis in the QSBS stock
The QSBS rules are undoubtedly complicated. To begin, the taxpayer can form the QOZB as an LLC that is taxed as a partnership. It will be converted into a C corp after start-up losses are incurred. Taxpayers must carefully evaluate the impact of double taxation and the loss of a tax step-up to the buyer in a sale transaction before they elect to convert into a C corp.
If the entity is sold within five years of becoming a C corp, 100% of the tax gain can be excluded within specified limits. Not all states conform. California, for example, is prohibited. In most states, the OZ investor gets double tax planning benefits; 1202 will be operative within five years after formation. There is no OZ gain exemption under the QSBS rules, but the $10 million exempt gain and the possibility to exit after five years rather than ten, more than makes up for this.
Additional tax mitigation is also likely since many of the OZ census tracts fall into federal and state tax incentive programs that include:
- Property tax
- Payroll tax
- Income tax
- Government grants
- Employee training programs
Opportunity Zones Types
Background On Opportunity Zones
- Opportunity zones were created by the Tax Cuts and Jobs Act. Opportunity Zones are economic development tools driven by tax incentives that allow people to invest in distressed areas.
- Its purpose is to drive economic development and job creation in distressed communities. Contiguous and low-income communities qualify as opportunity Zones once a state, the District of Columbia, or a US Territory nominated them, and the US Treasury certified the nomination.
- At present, 8.764 communities across the US are certified as Qualified Opportunity Zones.
- After the certification process, Congress designated all low-income communities in Puerto Rico as Qualified Opportunity Zones (QOZ).
- A list of QOZs is available at IRS Notices 2018-48.
Opportunity Zones (OZ) offer tax advantages to both businesses and individuals. Investors can defer tax on capital gains for a while if they invest their profits in capital gains in Qualified Opportunity Funds. The deferment of taxes on a capital gain will last until the investor sells or exchanges the QOF Investment, or on December 26th, 2026, whichever comes first.
Tax Benefits Are Determined By How Long Investment Is Shield
- Investment held for five years
The basis of the QOF investment increases by 10% of the deferred gain.
- Investment held for seven years
The basis of the QOF investment increases by 15% of the deferred gain.
- Investment held for ten years
The investor is now eligible to elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF is sold or exchanged.
Gains that become eligible to be deferred are called ‘eligible gains.’ Both capital gains and qualified 1231 gains qualify, if:
- Recognized for federal income tax purposes before January 1st, 2027
- They aren’t derived from a transaction with a related person.
- The amount was invested timely in a QOF in exchange for an equity interest in the QOF – hence if it is a qualifying investment.
Taxpayers can claim the deferral on their federal income tax return for the year in which the gain would have been recognized if they did not defer it.
Qualified Opportunity Funds (QOF)
These are investment vehicles that file a federal income tax return as a partnership or corporate entity, and which is organized for the purpose of QOZ property investment, and which:
- Self-certified as such by filing Form 8996 every year along with its federal income tax return. The form must be filed timely. Even LLCs that selected to be treated as a partnership or corporation for federal income tax purposes can organize as a QOF.
Qualified Opportunity Zone Property (QOZP)
QOZP is a QOF’s qualifying ownership interest in a corporation or partnership that operates a QOZ business in QOZ or specific tangible property of the QOF that is used in a business in the QOZ.
To be a qualifying ownership interest:
- The interest must be acquired after December 31st, 2017, only in exchange for cash.
- The corporation or partnership must be a QOZ business.
- The corporation or partnership must be in a QOZ business for 90% of the period of holding that interest.
Qualified Opportunity Zone Business Property (QOZBP)
This is defined as tangible property in the QOZ purchased after 2017, which is used in a trade or business AND:
- The original use of the property in the QOZ started with the QOF or QOZ business, OR,
- The property was substantially improved by the QOF or QOZ business, AND,
- During 90% of the period, the QOF or QOZ business held the property, generally speaking, at least 70% of the use of the property was in a QOZ.
A QOZ business must earn at least 50% of its gross income from business activities within a QOZ – every single year. To meet this test, three safe harbors are available:
- Half of the aggregate hours of services received by the business were performed in a QOZ
- Half of the aggregate amounts that the firm paid for services were performed in a QOZ
- The tangible property and necessary business functions to earn the income were located in a QOZ.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intended for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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