Understanding The Facts & Looking Beyond The Hype
The Tax Cuts and Jobs Act (TCJA) authorized the designation of certain economically disadvantaged communities referred to as Qualified Opportunity Zones (QOZ). Investing gains realized from other investments into QOZs provide for a temporary deferral of gains from the sale of property when these gains are invested in a Qualified Opportunity Fund (QOF), and a potential permanent exclusion from income if an investment in a QOF is held by a taxpayer for at least 10 years. This provision is intended to encourage economic investment and growth in these distressed communities. Remember, it is the gains that are reinvested, not the total proceeds.
What is a Qualified Opportunity Zone?
A QOZ is a designated area that is a low-income community. The IRS must certify and identify the community as a QOZ. The meaning of a low-income community is similar to that used for the new markets tax credit. It includes any population census tract with a poverty rate of at least 20 percent and also includes a tract whose median family income does not exceed 80 percent of the statewide median family income. For tracts located within a metropolitan area, the standard is 80 percent of the greater of a) statewide median family income or b) the metropolitan area median family income. With IRS guidance the state governors nominated specific tracts for designation as a QOZ. The nomination process needed to be completed no later than March 21, 2018. IRS Notice 2018-48 lists the census tracts that have been certified as QOZs.
What is a Qualified Opportunity Fund?
A QOF is any investment vehicle that 1) is organized as a corporation or partnership for investing in property in a QOZ and 2) at least 90 percent of its assets is QOZ property. The 90 percent test is fulfilled if the average percentage of QOZ property held by the fund on the last day of the first half of the tax year and the last day of the tax year is at least 90 percent. Note that a QOF cannot be organized for the purpose of investing in other QOFs. For each month that a QOF fails the 90 percent test a penalty is imposed for noncompliance. The penalty amount is computed as follows: (90 percent of aggregate assets − aggregate amount of QOZ property) × the underpayment rate for the month as defined by the IRS. The penalty is waived if the failure is due to reasonable cause.
Taxpayers self-certify to become a QOF. No approval or action by the IRS is required. A partnership or corporation self-certifies to become a QOF by completing Form 8996 (Qualified Opportunity Fund) and attaching it to a timely filed (including extensions) tax return. In addition, the tax return for the QOF will have additional questions to answer.
What is Qualified Opportunity Zone Property?
QOZ property includes the following:
- QOZ Stock – QOZ stock is stock acquired at original issue by the QOF after 2017, from a domestic corporation solely for cash. At the time the stock is issued, the main requirement is that substantially all the tangible property owned or leased by the corporation must be QOZ business property. The corporation must satisfy all requirements during substantially all of the QOF’s holding period in the stock.
- QOZ Partnership Interests – QOZ partnership interests are capital or profits interests issued by a domestic partnership for cash after 2017. The QOZ requirements explained earlier also apply to QOZ partnership interests.
- QOZ Business Property – This is tangible property used in a trade or business if 1) the property is purchased by the QOF after December 31, 2017; 2) the original use of the property in the QOZ starts with the QOF (or the QOF substantially improves the property); and 3) during substantially all of the QOF’s holding period in the property, substantially all of the use of the property is in a QOZ. To substantially improve property, the QOF must increase the basis of the property acquired by an amount that essentially doubles the basis within a 30 month period following acquisition.
What are the tax benefits of investing in a Qualified Opportunity Fund?
The two major tax benefits of investing in QOZs are:
- Temporary deferral of the gain from the sale of property when the gain is reinvested in a QOF.
- The permanent deferral of gain from the QOF.
The temporary deferral of the original gain that resulted from property sold to an unrelated person is deferred for any portion of the gain invested in a QOF within 180 days. There is no restriction on the dollar limitation of the amount of gain that can be deferred. This gain from the temporary deferral election is included in income in the tax year that includes the earlier of:
- The date on which the investment in the QOF is sold or exchanged or
- December 31, 2026.
The amount of gain included in income is the lesser of:
- The amount of gain excluded under the election or
- The fair market value of the investment.
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The includible amount is then reduced by the tax basis in the investment in the QOF. The tax basis in the investment is generally zero. However, the basis is increased by an amount equal to 10 percent of the gain temporarily deferred if the investment is held for at least five years and increased by an additional 5 percent of the gain deferred if the investment is held for at least seven years. If the investment is held until at least Dec. 31, 2026, basis is increased by the remaining 85 percent of the deferred gain.
If the QOF investment is held for at least 10 years, there is a permanent deferral of post-acquisition gain the from the QOF investment upon disposition. This is accomplished by increasing the investment’s basis to its fair market value on the date the investment is sold or exchanged. The permanent deferral election does not prevent the recognition of gain that was deferred under the temporary gain deferral election. Since it is not possible to hold the investment for 10 years prior to Dec. 31, 2026, the permanent exclusion election only excludes gain in excess of the deferred gain. Therefore, only post-acquisition gains are excluded. The gain from the QOF sale is reported on Form 8949, Sales and other Dispositions of Capital Assets.
Because of the way the tax code is written, to receive the full benefits of a QOF, the latest date to invest in a QOF is Dec. 31, 2019. Past this date, investors will lose out on basis increases.
Taxpayer has an unrealized long term gain of $1,000,000 from the sale of stock purchased in 2010. The gain was realized on Oct. 15, 2018. Taxpayer has 180 days (until April 1, 2019) to make a decision to reinvest the gain into an investment in a QOF. The tax deferred will be $238,000 ($1,000,000 x 23.8 percent).
Taxpayer decides to invest in a QOF that is organized as a partnership and its capital is invested in various operating businesses that are located in designated QOZs. Taxpayer QOF invests at least 90 percent of its assets in QOZ property. In 2027, the investment is sold when the QOF is worth $2,000,000 ($1,000,000 of appreciation).
The potential tax benefits are as follows:
- Temporary deferral of the gain –15 percent of the deferred realized gain will be excluded since the QOF was held for more than seven years. Capital gain tax of $202,300 will be due in 2026 on the original deferred gain ($1,000,000 x 85% x 23.8 percent).
- Permanent deferral of gain –There is no tax due on the $1,000,000 of post-acquisition gain form QOF.
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Looking beyond the hype
The QOFs have seen a lot of hype. Although QOFs provide an opportunity to defer and permanently exclude gains from income, should taxes be the only focal point? Promoters may see this as an opportunity to service the demands of investors while increasing their bottom line through management fees. What was the goal of legislators when they put this into the law? Why were tax incentives needed to encourage investing in these areas? Some high net worth investors may look at this as a way to give back to under-served communities. Others may not even be considering a downside.
Overall financial investing needs to have a purpose and be part of an overall financial plan. This is a long-term investment with many unknowns and no historical benchmarks. What is the liquidity of this type of investment?
Reviewing potential financial investments requires due diligence, a financial plan, and a review of the projections for the investment. Although the QOFs provide an opportunity for tax savings, the unknowns need to be reviewed from a long-term perspective.
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By Cindy Kula, CPA/PFS, CFP® (Cleveland office)