Basis Increases the Longer Investment is Held in Qualified Opportunity Funds
Real estate developers and investors have the opportunity to invest in distressed communities throughout the U.S. with tax benefits unlike any other development incentive structure. However, to achieve the maximum benefit of Opportunity Zones, they must act by Dec. 31, 2019.
Courtesy of the Tax Cuts and Jobs Act (TCJA) of 2017, the Investing in Opportunity Act created great buzz among the real estate community with the introduction of Opportunity Zones, a tax-incentive tool intended to spur economic development and job creation in low-income communities throughout the U.S. Anyone with a capital gain is eligible to participate, and the capital gain can come from any type of property, including public stocks, mutual funds, private businesses or real estate.
The IRS has certified 8,700 approved Opportunity Zones for investment in all 50 states and in every major metropolitan area through the creation of Qualified Opportunity Funds (QOFs). In 2019, the IRS added two additional QOZ census tracts in Puerto Rico.
Opportunity Zones are substantially different than other tax benefit programs. Rather than just getting a deferral upon a realized event, QOZ investors can access additional benefits based on how long the funds are held. Along with the deferral, there is an exclusion factor built into the program. The goal is to encourage the investor to commit long-term in the community.
When the TCJA was enacted, there were few rules in place about QOFs and the implementation of Opportunity Zone investments. Since then, the U.S. Treasury has released several rounds of guidance, with final rules expected by the end of this year. The guidance is needed—investors want to roll gains from 2018 into QOFs and have 180 days from the tax-year end date (usually 12/31) to roll gains into a QOF.
Qualified Opportunity Funds
QOFs are partnerships or corporations (but not S corporations) formed specifically to invest in Opportunity Zones. The QOFs, which either run the business or invest in others doing business in the state, are formed through a corporate entity or a partnership, with an emphasis on the latter.
There are numerous benefits to investing in an Opportunity Zone:
- Investors can defer tax on any prior gains until the earlier of the date on which an investment is sold or exchanged, or Dec. 31, 2026, as long as the gain is reinvested in a QOF within 180 days of the gain occurring.
- Capital gains on investments in QOFs held for five years are reduced by 10%; if held seven years, they are reduced 15%.
- If an investor holds their investment in a QOF for 10 years or more, their basis will be equal to the fair market value of the investment, thereby creating a permanent capital gain exclusion.
Assume Investor X sells publicly traded stock on March 1, 2019 for $3M with a tax basis of $1M, resulting in a long-term capital gain of $2M. X invests $2M (only the gain needs to be reinvested) in a QOF on June 30, 2019 (well within the 180-day requirement).
X may elect to defer the recognition of gain on the 2019 tax return. Tax basis is zero at this point.
2. Exclusion of 10% of the Gain
If the investment is held for five years, the tax basis increases by 10% or $200,000, basically providing an exclusion of the $200,000.
3. Exclusion of the 5% of the Gain
If the investment is held for another two years, the tax basis increases by another 5 percent or $100,000, basically providing another exclusion of $100,000. So in order to benefit for the 5% exclusion, the investment has to be made by the end of 2019, since the deferred gain is automatically triggered on Dec. 31, 2026. Therefore, the balance of the gain of $1.7 million is recognized in 2026. The tax basis is now $2M.
If X holds for 10 years, no gain is reported on the sale of the QOF investment. So if X sells the QOF investment for $5M on Nov. 1, 2021, the $3M gain is not recognized.
As the greatest incentive to investors, and as the example illustrates, there are no capital gains taxes on any investment held in a Qualified Opportunity Zone Fund, if held for 10 years or more. But, here’s the kicker—the Opportunity Zone program is set to expire Dec. 31, 2026. That means an investor has until Dec. 31, 2019 to invest in the funds to realize the maximum benefit of the legislation.
Further Guidance Expected
Since the establishment of Opportunity Zones, Treasury has issued guidance to make clarifications about implementation of the tax benefit. Some of these include:
- Multi-asset funds structures will be treated favorably
- Underlying sales of assets would not trigger a capital gain for fund investors
- The testing of funds for compliance was loosened (for rules around working capital and timing aspects)
- For purposes of the requirement that “substantially all” of a partnership’s or corporation’s property owned or leased must be qualified Opportunity Zone business property, “substantially all” means 70 percent
- A partnership format will be permitted to refinance properties and return capital to investors without triggering a capital gain, up to the basis in the fund
- The ability to make an election to increase basis to fair market value on the sale of a QOF interest is not impaired by the expiration of the designation of the zone at the end of 2028.
The rules remain complex; as we await further clarification, the IRS has issued an updated Q&A on the QOZ program. Do you have questions about Opportunity Zones and QOFs? Contact Robert H. Sacks, Tax Partner, at 561-953-1488 or email Rob.