How To Use Real Estate Opportunity Zone Investments For Tax Deferral
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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
According Forbes.com. 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.
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%|
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.
By rolling capital gains into a QOF, you incur lots of benefits:
- 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.|
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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