With a volatile stock market, unclear future economic picture and an uptick in commercial and multifamily real estate and valuations of privately-held businesses, many high net worth taxpayers are selling off real estate assets and taking their concentrated stock positions off the table.
These large liquidity events are exactly what the 2017 tax law had in mind when the federal Qualified Opportunity Zone program was introduced. The QOZ program encourages the private sector to liquidate highly appreciated assets and to diversify their investment portfolios while revitalizing urban and rural districts that face economic challenges. The long-term objective of the QOZ program is to build wealth in communities that need it most and to save money for participating investors by reducing their federal capital gains taxes.
For starters, the QOZ program allows your clients to avail themselves of long-term tax deferral and escalating tax exemptions as they hold qualifying replacement investments. It also allows them to diversify profitably into real estate or other qualifying business ventures that operate primarily within a QOZ.
While the opportunity zone program has created tremendous interest throughout the real estate and financial advisory worlds, many investors have been waiting on the sidelines until a more complete set of guidelines are provided via federal regulations. While hundreds of OZ funds have already been established, once additional clarifying regulations are issued, billions of dollars of additional OZ funds will be pouring money into these 8,700 underserved census tracts.
New Guidance
The recent (Feb. 14) IRS hearings in Washington, D.C. allowed investors and financial advisors to share their suggested program refinements with IRS and Treasury personnel. Two additional sets of regulatory guidance expected next month should remove more of the remaining uncertainty about the program. I urge you and your colleagues to get up to speed on the QOZ program. It has wide applications for your high net worth clients and could be a lucrative new service niche for your practice.
The six-month window for OZ funds to hold capital before investing it into a QOZ property (without penalty) is likely to be extended since investors must be given adequate time to evaluate re-investment options. The timing of deploying the funds from the OZ fund level to the subsidiary level also needs more clarification to avoid being subjected to the 6 percent annual penalty for under-investing.
There should soon be more clarity around whether a fund can sell individual assets in which it invests (versus being forced to sell at the OZ fund level) and whether or not to reinvest those new proceeds in a reasonable time frame to deploy to additional QOZ projects without losing the tax benefits.
Restrictions should be loosened on funds investing in businesses located within opportunity zones. The law was crafted to include investments in companies and real estate, but the first set of proposed regulations makes it difficult for funds to put money into operating businesses.
Finally, experts suggest that the IRS allow employee participation in the OZ business ventures in order to spread the wealth of the program.
Here are some of the most important facets of the QOZ program that you and your colleagues should consider:
1. Overview
The federal QOZ program was introduced effective Jan. 1, 2018 as part of the 2017 Tax Cuts and Jobs Act. The QOZ program is a highly flexible tax deferral and permanent savings program available to your individual and business clients that are holding appreciated assets. The program offers taxpayers a unique opportunity to divest out of their concentrated appreciated asset positions and to move the associated deferred tax gain into one or more asset classes as tax-efficiently as possible. Unlike a 1031 like-kind exchange, the QOZ program is not limited to clients with real estate gains and does not require them to reinvest those gains in similar real estate properties. Real estate gains can now be moved into a wide variety of projects within a designated QOZ, including qualifying businesses, startups and other ventures.
2. Which gains are eligible
The deferred tax gain from the original sell transaction can be related to a wide variety of capital assets sold (or disposed of) by the investor: land, developed real estate, stock or bond portfolios, artwork, collectibles, bitcoin or other cryptocurrencies, as well as other tangible and intangible assets. Note that accumulated depreciation and amortization on the asset(s) will generally represent non-eligible “ordinary” gain. The deferred tax gain must be reinvested into a Qualified Opportunity Zone Fund (QOF) within 180 days of recognizing the tax gain on sale. Note that there are beneficial timing rules for gains reportable from partnerships, S corps, trusts and real estate investment trusts, which generally delays the initial gain reporting until Dec. 31, which is the start of the 180-day reinvestment period. Timely reinvestment of the gain into an OZ fund will generally allow deferral of the original gain reporting until the earlier of Dec. 31, 2026 or the date the QOF is sold.
3. When a 1031 like-kind exchange is the better option
Investors in high-tax states that have not adopted the QOZ program (i.e., California) should consider a Section 1031 transaction rather than a QOF reinvestment if the assets involved are 100 percent real estate. That will also defer the California state tax. This is even more important if the investor is older or in poor health since the real estate will generally get fully “stepped up” to fair market value upon death in a 1031 transaction, which is not the case with a QOF. Another difference between 1031 and QOF investing is that only the capital gains portion (all or just a percentage) of the transaction needs to be reinvested, whereas a 1031 requires all proceeds (and possibly debt amounts) to be reinvested or matched. So a QOF strategy can provide your client with immediate tax-free liquidity to the extent of the investment’s tax basis.
4. Qualified Opportunity Fund requirement
If you have clients wishing to invest in one of the nation’s 8,700 designated QOZs, they must do so through a QOF. Your clients cannot make direct investments in properties or businesses within a QOZ they like — they must invest through a QOF or start their own QOF. The statute provides a fairly straightforward process to meet the QOF requirements. The entity must be either: i) a C corporation, ii) an S corporation or iii) a partnership (including an LLC electing to be taxed as a partnership). A QOF can represent a single investor or multiple investors.
5. Tax basis adjustments/gain reporting and exemption
The federal tax impact of participating in a QOF includes deferring qualified gains for up to eight years and also permanently exempting 10 to 15 percent of the original federal gain and 100 percent of the post-reinvestment gain — after holding the investment for 5, 7 and 10 years, respectively.
Here's a real-world example: Let’s say a taxpayer invests $1 million of deferred tax gain into a QOF on June 30, 2019. He or she will start with a $0 tax basis in the QOF since the gain has not been recognized. On July 1, 2024, after meeting the five-year holding requirement, the taxpayer will receive a 10 percent step-up to $100,000, leaving $900,000 of deferred tax gain. At July 1, 2026, the seven-year step-up of an additional 5 percent will bring the cumulative tax basis to $150,000 and lower the deferred gain to $850,000. On Dec. 31, 2026, the deferred gain of $850,000 will be included in the taxpayer’s 2026 tax return and their QOF tax basis will then be $1 million ($150,000 basis step-up + the $850,000 deferred gain recognized).
Once the investor has held the QOF for at least 10 years, the tax basis in the QOF will fluctuate with the changing fair market value, and the taxpayer can elect to exempt the post-investment federal tax gain upon disposition for as long as 2046, thus allowing decades of potential tax-free appreciation. However, the election will not be advisable in a situation in which the investment loses value before sale.
There will be many open issues surrounding the program and additional guidance is expected in the near future. Still, taxpayers who have already sold an asset at a large capital gain should consider forming a QOF in order to “park” the gain within 180 days for future reinvestment once more guidance is provided. In Part 2 of this article, we’ll discuss recommended legal entities, original use and rehab requirements, types of businesses that don’t qualify for QOZ investment, and the types of clients best suited for the program.
