The 2017 Tax Act adopted special benefits for taxpayers looking to prevent taxation of capital gains, which will also assist the real estate market in 1,000s of economically distressed communities across the country. The IRS recently released proposed regulations and guidance, which are helpful and should stimulate use of this new tax motivated investment option. If an investor recognizes a long term capital gain (“LTCG”) from the sale of stock or other assets and within 180 days of the sale, the investor makes a cash investment equal to the LTCG in a Qualified Opportunity Zone (“QOZ”) Fund then the investor can get the following tax benefits.
First, the taxpayer can elect to defer recognition of the LTCG until the earlier of (1) the date the taxpayer sells their interest in the QOZ Fund or (2) 2026. Also, unlike a §1031 tax-free like-kind exchange , there is no requirement to invest the entire sale price in the QOZ Fund to get tax deferral; the taxpayer only has to invest the gain to get tax deferral.
Second, there is a permanent reduction in part of the deferred LTCG from the original investment if the investment in the QOZ Fund is held for at least five years before sale. If the QOZ Fund investment is held for 5 or more years, then the deferred gain will be reduced by 10%. If the QOZ Fund is held for 7 or more years, the deferred gain is reduced by 15%. Also, whenever the deferred gain is recognized, the tax basis of the QOZ Fund is increased by the gain that is then recognized.
Third, if the investor has patience and can delay the sale of their interest in the QOZ Fund until they have held the investment for 10 years or more then the tax basis of the investment is increased to the fair market value of the investment on the date of sale. This “step-up” in tax basis effectively eliminates any federal income tax on the sale. These tax benefits will stimulate long-term investments in QOZ Funds.
What is a QOZ? A state can designate any economically distressed area as a QOZ, which can include select parts of cities and townships. The U.S. Treasury Department must then consider whether to certify that designation as being a QOZ. A map showing certified QOZs is available on the internet, https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml. Around 8,000 areas have been designated as QOZs.
What is a QOZ Fund? A QOZ Fund is a corporation or partnership if 90% or more of its assets consist of QOZ Property, as described below. Unlike prior tax programs that were targeted to housing (e.g., low income tax credits), the QOZ Fund can invest in QOZ commercial real estate or any trade or business such as an operating business located in the QOZ. Thus, they are more flexible. A QOZ Fund self certifies its compliance with applicable requirements on Form 8996. As a result, an investor in a QOZ Fund needs to be confident that the fund qualifies as a QOZ Fund.
QOZ Property is QOZ Business Property, QOZ Partnership Interests or QOZ Stock. QOZ Business Property is tangible property located in the QOZ that was acquired by purchase from unrelated parties; other conditions also need to be met. QOZ Partnership Interests and QOZ Stock are investments in partnerships and corporations that meet certain conditions aimed at making sure they benefit the QOZ.
How is a Partnership’s Capital Gain treated under these rules? In its recently released guidance, one important item addressed is how to deal with a capital gain recognized by a partnership so as to obtain tax deferral under the QOZ Fund rules. The partnership has 180 days from the date of the sale generating the capital gain to invest the capital gain in a QOZ Fund. If the partnership makes that investment within 180 days of the sale, then tax deferral and related tax benefits apply for all partners. However, that 180 day period may have already passed for sales made in early 2018. Also, other partnerships may choose to not reinvest.
If the partnership does not invest in a QOZ Fund, then each partner can choose to reinvest their share of the capital gain into a QOZ Fund and get tax deferral and the tax benefits described above. That partner must make that investment within 180 days of the end of the partnership’s taxable year, and not the actual date of the partnership’s sale. This approach gives partners in a partnership a second bite at the apple to invest the capital gain in a QOZ Fund and gives them added time to make that decision well after the tax year is over. Also, a partner could make this investment earlier if the partnership has recognized a capital gain and the partnership indicates it will not reinvest the sales proceeds in a QOZ Fund. In that case, the partner can elect to start the 180 day period on the date the partnership sold the asset that generated the capital gain. A partnership may decide that giving each partner the option to invest in a QOZ Fund may be preferable since it gives each partner more flexibility in choosing what fund to invest in, if any, and when to sell it.
Conclusion: The bottom line is investing in a QOZ Fund has major tax advantages that deserve its consideration. Also, unlike other tax programs targeted to low income areas (such as the low income housing tax credit), this tax incentive is not restricted to only providing assistance to low income people. Rather, the QOZ Fund can invest in real estate or certain operating businesses that may have significant profit potential. As a result, the QOZ Fund can offer both tax benefits and economic benefits. Investors need, however, to make sure the QOZ Fund is properly managed and compliant with all tax rules to better assure these benefits may materialize.
[i] Philip is the Vice Chair of the Committee on Federal Taxation of Real Estate within the Real Property Trust and Estate Section of the American Bar Association and a frequent author and lecturer on tax topics of interest to the real estate community. To learn more about Philip or contact him with questions, see http://www.coleschotz.com/PhilipHirschfeld.