In 2017, the Tax Cuts and Jobs Act (TCJA) featured the Qualified Opportunity Zone (QOZ) provision – Code Section 1400Z. While the provision was mostly overlooked at the time, it has now integrated itself into the lexicon of investment advisors. With the ability to defer, or even to some degree eliminate, tax on capital gains, it is easy to understand. But, for investors looking to take full advantage of the benefits, time is starting to run out.
What’s in this article?
- What is the qualified opportunity zone program?
- Which communities qualify and what are their attributes?
- How are invested funds designated, applied and reported?
- What are the qualified opportunity zone requirements?
- What classes of investments qualify?
- What are the tax benefits of a qualified opportunity zone?
- Where does the greatest opportunity lie?
- What are the most recent proposed regulations for qualified opportunity funds?
- How can Squar Milner help?
What is the qualified opportunity zone program?
The TCJA introduced the federal Opportunity Zone program as an effort to increase investment in economically distressed communities throughout the United States. At its core, the program intends to encourage the private sector to liquidate their highly appreciated assets and diversify their investment portfolios while simultaneously revitalizing urban and rural districts facing considerable economic challenges. In order to incentivize investors, the program provides preferential capital gains treatment for investments within designated low-income census tracts.
Officially in effect since January 1, 2018, the QOZ program is a highly flexible tax deferral and permanent savings program available to individuals and businesses holding appreciated assets. The program is a unique opportunity which allows taxpayers to divest out of their concentrated appreciated asset positions and move the associated deferred tax gain into one or more asset classes.
Separating itself from a 1031 like-kind exchange, the QOZ program does not limit itself to clients with real estate gains and it does not require them to reinvest those gains in similar real estate properties. Rather, under the QOZ program, the investor has the capability to move the real estate gains to a wide variety of projects within a designated QOZ, including qualifying businesses, start-ups, and other ventures.
The QOZ program promotes three significant tax benefits to encourage economic growth in specified economically distressed communities. These three include: a deferral of capital gain recognition, an exclusion of income from that gain, and exclusion from income of certain post-acquisition gains.
Which communities qualify and what are their attributes?
A Qualified Opportunity Zone is a low-income census tract. More specifically, it is an area, identified through the U.S. census, as having a poverty rate of 20% or more and a median family income of 80% or less of the area’s median income. It is the responsibility of the governor of each state to designate up to 25% of these census tracts as QOZs. A QOZ then retains the designation for 10 years. To see the current QOZs in the state of California, click here.
In 2018, more than 8,700 communities throughout the United States, the District of Columbia, and some U.S. territories received classification as a Qualified Opportunity Zone. The governors of the states and territories, along with the Mayor of Washington D.C., nominated the zones which were then officially recognized by the U.S. Department of Treasury.
Research efforts undertaken by the Urban Institute reveal that the officially designated zones have lower incomes, higher poverty rates, and higher unemployment rates than eligible non-designated tracts. Also, home values, rents, and home ownership rates are lower in these areas.
How are invested funds designated, applied and reported?
The deferred tax gain from the original sell transaction can relate to a wide variety of capital assets sold or otherwise disposed of by the investor. These include: land, developed real estate, stock or bonds, artwork, collectibles, Bitcoin and other virtual currencies, as well as other tangible and intangible assets.
Then, if the taxpayer plans to participate in the QOZ program, they must reinvest the deferred tax gain into a Qualified Opportunity Fund (QOF). You cannot make direct investments in properties or businesses within a QOZ, rather you must invest through a QOF. Prospective investors have the option to start a QOF on their own or join an existing one. To meet the QOF requirements the entity must either be a C corporation, S corporation, or a partnership (including LLCs taxed as a partnership). A QOF can represent a single investor or multiple.
Investors seeking to participate in a qualifying investment must make a direct contribution of cash or property to a top-level investment entity that elects QOF treatment or purchase a direct interest in a QOF from another party.
QOF investors must self-certify through IRS Form 8996. This form, filed with the fund’s federal tax returns, reports the initial investment, certification and ongoing compliance testing.
What are the qualified opportunity zone requirements?
The qualified opportunity zone statute and proposed regulations establish a general framework for QOZ investment through the QOF investment vehicle. However, it is critical to understand other QOZ investment requirements:
1. Initial investment
After recognizing capital gain from the sale or exchange of an asset to an unrelated party, investors have up to 180 days to make an investment in a QOF that will qualify for QOZ tax benefits. Generally, the 180-day investment period begins on the day the gain would have been recognized for federal tax purposes.
For partnerships who recognize a capital gain, the partnership has the ability to reinvest the gain or the partners may elect individually. If the partnership elects to defer the gain, then the 180-day period begins on the day the partnership would have recognized the original gain. On the other hand, if a partner/shareholder/beneficiary makes an individual election, they can choose to either begin the investment period on the last day of the tax year of the partnership, or if beneficial, they can elect to start as of the gain recognition date.
Under the new regulations and specific to Section 1231 gains, the reinvestment period also begins on the last day of the tax year of the entity that recognizes the gain.
2. 90% assets test and QOZ property
In order to avoid monetary penalties, the QOF must treat at least 90% of the assets as “qualified opportunity zone property.” This is the 90% assets test. QOZ property may consist either of direct investments in a “qualified opportunity zone business property” (tangible assets located in a QOZ that satisfy other requirements) or investments in an entity known as a “qualified opportunity zone business” that, in turn, invests in a QOZ business property.
Generally, investors must perform the 90% assets test on June 30th and December 31st every year. However, the initial testing date is six months after the formation of the QOF, but no later than December 31st of the initial year. Subsequent cash contributions initiate a new initial testing date so they are eligible for the full six month window to invest qualified property. Also, the QOF has a 12-month period to reinvest any return of capital from qualifying investments into new qualifying investments, provided the proceeds consist of cash, cash equivalents or securities with a maturity of 18 months or less. The proceeds are eligible for reinvestment in any type of qualified investment.
Note that there is an exclusion available for working capital that is subject to a written plan to acquire, construct or rehabilitate QOZ property within 31 months of the formation of the fund. The QOF must also demonstrate that the working capital is being used pursuant to the plan throughout that 31 month period.
Under new regulations, the written plan required by the working safe harbor can now include a plan to develop a qualified trade or business during the 31-month period. Also, exceeding the 31 month period does not violate safe harbor laws if the delay is attributable to waiting for government action, as long as the investor completed the application during the 31-month period.
3. Business requirements
There are other distinct QOZ business requirements:
- 70% tangible assets test – At least 70% of the tangible property owned or leased by a QOZ business must be treated as QOZ business property.
- Intangible property test – The active conduct of business in the QOZ must use at least 40% of the QOZ business’s intangible property.
- Nonqualified financial property test – Less than 5% of the aggregate unadjusted bases of property used by a QOZ business can be attributable to “nonqualified financial property.”
- Gross income test – At least 50% of the total gross income of the QOZ business must result from the active conduct of business in the QOZ.
- Sin business limitation – Certain types of businesses, known as “sin businesses,” are ineligible for opportunity funds, even if they exist within opportunity zones. These businesses include:
- Golf courses
- Country clubs
- Massage parlors
- Hot tub facilities
- Suntan facilities
- Racetracks or other facilities used for gambling
- Liquor stores
What classes of investments qualify?
“Tangible property used in a trade or business” includes:
- Real property, improved or unimproved;
- Trade or business if it stays within the opportunity zone for the duration of the investment;
- Original use property must commence with opportunity zone business if it is not substantially improved
- “Substantial improvement” by a QOZ fund (“equal or more” rule) requires additions to the basis of the acquired property within 30 months following its acquisition in excess of the adjusted basis of the acquired property.
Original use/substantial improvement issues
For the purposes of a real estate acquisition in a QOZ, there is no designation as “original use property” unless the structure on the property has been vacant for 5 years prior to the acquisition by the QOF.
When determining basis subject to substantial improvement requirements, proposed regulations and Internal Revenue Service (IRS) guidance provide that 1x basis improvements are only applicable to improvements to the building and based on the acquisition cost allocated to the building only.
Qualified trade or business/substantially all provisions
There are a number of different “substantially all” provisions to be aware of:
- In order for a trade or business to satisfy the “substantially all” test, at least 70% of its tangible owned or leased property must be qualified opportunity zone property;
- To meet “substantially all” requirements for the use of property in a QOZ, at least 70% of the qualified business property must be used in a QOZ;
- To meet the “substantially all” requirements for the holding period, the business property must be qualified for at least 90% of the holding period of such property
- The 90% holding period requirement also applies to the holding of qualified opportunity zone stock or partnership interests.
In addition to the above requirements, a qualified trade or business must meet revenue and IP utilization requirements. New regulations propose several safe harbor provisions to meet those requirements.
Qualified trade or business safe harbor provisions
A qualified trade or business must derive at least 50% of its revenue from the opportunity zone. The Treasury Department has proposed the following safe harbors to meet this requirement:
- At least 50% of the services performed (based on hours) by the employees and independent contractors are performed within the zone.
- At least 50% of the services performed (based on wages) by the employees and independent contractors are performed within the zone.
- The tangible property located within a zone and the management/operational functions located within a zone are necessary to generate at least 50% of the gross receipts.
- Taxpayers can use facts and circumstances test if the above safe harbors are not met.
What are the tax benefits of a qualified opportunity zone?
The qualified opportunity zone program offers three notable tax benefits for investing unrealized capital gains in qualified opportunity zones:
1. Temporary deferral of taxes on previously earned capital gains
Investors can place existing assets with accumulated capital gains in qualified opportunity funds within 180 days of realization (see above). Capital gain reporting and taxation are deferred until the end of 2026 or whenever the asset is sold or exchanged.
2. Basis step-up of previously earned capital gains invested
If the investor holds the asset for more than five years, the adjusted basis increases by 10% of the gain deferred. In addition, if the investor holds the asset for more than seven years, the basis increases up to 15% of gain deferred. This means that the taxpayer can exclude up to 15% of the value of the reinvested capital gains from their taxable income, decreasing their tax liability when they sell or can no longer defer taxation.
3. Permanent exclusion of taxable income on new gains
For investments held for at least 10 years, investors pay no taxes on any capital gains produced through their investments in QOFs. Opportunity zones increases the basis of any investment held in a qualified opportunity fund for 10 years to 100% of its fair market value on the sell or exchange.
Tax Benefits Timeline
The chart below shows the timeline for the qualified opportunity zones tax benefits:
Where does the greatest opportunity lie?
There are three particular groups with special interest in QOZs:
- Optimal buyers are taxpayers who have just had or will have a major liquidity event from a sale of securities or business
- Optimal sellers are present owners needing to package assets for sale
- Optimal exchangers include those approaching the 180-day mark without a suitable leg-up. They should consider collapsing the exchange and using a QOZ approach instead.
What are the most recent proposed regulations for qualified opportunity funds?
On October 31, 2019, the IRS and the Treasury Department released a draft version of a proposed tax form to collect information pertaining to QOFs. The proposed IRS Form 8996, Qualified Opportunity Fund, intends to gather pertinent information regarding QOFs. For instance, the form asks for information about the total qualified opportunity zone property held by the taxpayer on the last day of the first six-month period of the taxpayer’s tax year. It also allows the taxpayer to calculate any tax penalty if the opportunity zone fund has failed to maintain the necessary investment standards. Furthermore, the form collects information on the amount of investment by QOFs in business property by census tract.
Treasury Secretary Steven T. Mnuchin explains, “We want to understand where Opportunity Zone investments are going and strengthening the economy so that investors and communities can learn from the successes of this bipartisan, pro-growth policy.”
Ideally, the information will permit the Treasury Department to assess the amount of investments various tracts receive over time. In addition, by concurrently monitoring the investment information and data on employment and incomes, policymakers and the public will be better able to evaluate the effects of the opportunity zone tax breaks and to understand why some locations are more enticing to investors.
How can Squar Milner help?
With the December 31, 2019 deadline fast approaching, the time to act is now. Factor in the complex requirements for qualified opportunity zones and qualified opportunity funds, and it can be very intimidating. So let us help.
Squar Milner offers an experienced Real Estate practice with considerable expertise to assist you with taking advantage of the opportunity zone tax benefits. We offer skilled tax planning and strategies to help maximize your tax savings. Reach out today to start capitalizing on the opportunity zones tax breaks before the December deadline.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.