The Opportunity with Opportunity Zones: Encouraging Long-Term Investments
The Tax Cuts and Jobs Act (“TCJA”) enacted a new opportunity to incentivize real estate investment and development in low-income communities across the country. This new incentive creates Qualified Opportunity Zones (“QOZs”) in which investors who previously recognized a taxable gain can defer or eliminate it by investing the gain proceeds into a Qualified Opportunity Fund (“QO Fund”). QOZs are designated low-income housing communities in the United States (or Puerto Rico) in which a population census tract is above the poverty rate, or median family income does not exceed a percentage of the statewide median family income.
On October 19, 2018, the Internal Revenue Service released proposed regulations for QOZs. These proposed regulations have been long awaited and are likely to spur even more activity from investors and funds who were awaiting guidance and hoping to close deals before the end of 2018.
The Tax Incentive to Invest in a QO Fund
- Tax deferral of previous disposition gain.
The investor interested in benefitting from this newly created program must invest their capital gain from a previous transaction in a QO Fund. Please note that this can be any gain from the sale of real or non-real property. The gain is deferred by investing the amount of the gain into a QO Fund, hence the return of the capital portion does not need to be invested in order to benefit from the deferral. The investment must be made within 180 days after the sale of the property which triggered the gain. The gain is deferred to the earlier of (i) the date on which a QO Fund is disposed or (ii) December 31, 2026.
- Basis increase of a QO Fund.
An investor’s initial tax basis of a QO Fund is initially zero since the cash being invested is from a transaction in which the gain is being deferred. However, if the investor holds its interest in a QO Fund for at least five years, the tax basis is increased by 10% of the deferred gain; if the interest is held for at least seven years, the basis of the deferred gain is increased by an additional 5% of the original gain. Hence there is a potential of an overall basis step up of 15% on the deferred gain.
- Elimination of the gain on certain properties held by a QO Fund.
Investors that hold the Opportunity Fund investment for at least 10 years can receive the added benefit of paying no tax on any realized appreciation in investments made with the QO Fund. Please note that this permanent exclusion would only be beneficial for any gain appreciation after December 31, 2026 since the original gain which was invested in the QO Fund will need to be recognized.
Qualified Opportunity Zone Designations:
There are approximately 8,700 Opportunity Zones throughout the U.S. spanning low-income areas of major cities.
The New Jersey approved designations include (but are not limited to) tracts of land in the Atlantic, Bergen, Camden, Essex, Hudson, Middlesex, Monmouth, Morris, Ocean, Passaic and Union Counties. Please click here to reference the complete list.
The New York approved designations include (but are not limited to) tracts of land in the Bronx, Kings, New York (Manhattan), Nassau, Queens, Richmond (Staten Island), Rockland, Suffolk and Westchester Counties. Please click here to reference the complete list.
QO Funds and the Certification Process:
A QO Fund is designed to be an investment vehicle that is set up as either a partnership or corporation by investing at least 90% of its assets in an eligible QO Zone Property (i.e. 90% Asset test). A QO Zone Property is either one of the following: QO Zone Business Property, QO Zone Stock, or QO Zone Partnership Interest.
QO Zone Business Property is tangible property used in a trade of business and meets the following requirements:
- the property must be acquired by the fund by purchase and from an unrelated party to the fund; and,
- the original use of the acquired property must start with the QO Fund; or,
- the QO Fund substantially improves the used property.
Substantial improvement standard is met if the additional improvements to the newly acquired property exceed the cost allocated to the building portion only. For example, if a fund were to pay $1 million for a warehouse and land, with the building valued at $400,000, the fund must spend at least what the building is valued in order to meet the substantial improvement standard. Another wrinkle is that the improvements must be done within 30 months from when the property is acquired in order not to violate the QOZ 90% Asset test.
A domestic corporation or a partnership will be treated as either QO Zone Stock or QO Zone Partnership Interest if such entity was acquired by a QO Fund after December 31, 2017, and solely for cash.
The certification process to become a QO Fund is a self-certification process in which the corporate or partnership entity will self-certify by attaching a Form 8996 to their timely ﬁled federal income tax return for the tax year. No approval or action by the IRS is required.
If at any year the QO Fund holds less than 90% of the QO Zone Property, it would be subject to a penalty for each month it fails to meet the requirement.
How the Deal is Structured:
- A QO Fund is formed and self-certified.
- An investor with a recently realized gain elects to invest this gain into the QO Fund, taking stock or partnership interest in return. By so doing, the investor gets to defer the gain. Please note that the investor is required to invest only the amount of the capital gain to be deferred.
- The QO Fund uses the investment to acquire a QO Zone Property. This investment represents the QO Fund’s interest in the underlying business in the low-income community.
- If the investor sells or exchanges his QO Fund interest before December 31, 2026, the investor will recognize the deferred gain. However, if the investor holds the investment for at least 5 years, the investor will receive a 10% step up in basis in connection with the original gain.
- On year seven, the investor receives an additional 5% step up in basis in connection with the original gain, so 15% of the gain is reduced.
- By December 31, 2026, if the investor has not sold the interest associated with the original gain, they must then recognize the gain. Please note that if the investment was held by at least seven years, the investor would only pick up 85% associated with the original deferred gain.
- If the investor holds their interest in the QO Fund for at least 10 years, the investor would not owe any tax related to any QOZ property which has been appreciated during such time.
Investing within a Qualified Opportunity Fund can be truly beneficial to anyone will a large capital gain, real estate owners, operators and developers who are seeking significant tax incentives by deferring and reducing their existing capital gains and eliminating any potential future capital gains within a Qualified Opportunity Zone investment. This new opportunity will spur long-term capital investments to low-income communities throughout the country that would otherwise not have been able to attract this investment capital. The advisors at Sax will be sure to release updates and further information on Qualified Opportunity Funds as they emerge. For any questions or additional information needed at this time, please feel free to reach out to Sax’s Real Estate Practice.
Michael Benguigui, CPA is a Senior Manager at Sax LLP and a member of the firm’s Tax and Real Estate Practices. He specializes in tax and accounting services for property owners, developers and private equity investors. Michael can be reached at [email protected].