In an effort to revitalize economically distressed communities around the country, Congress included in the Tax Cuts and Jobs Act a program that gives individuals and businesses preferential federal tax treatment when they reinvest capital gains into low-income communities. However, to reap the benefits of the newly enacted legislation and other valuable tax incentives offered by local governments, investors must understand how the program works and how they may qualify for it.
The Basics of Opportunity Zone Investments
The new legislation gave governors the ability to designate up to 25 percent of their state’s low-income census tracts to serve as Opportunity Zones (OZs) eligible for capital investment. As of June 2018, the Department of the Treasury has certified 8,762 OZs representing all 50 U.S. states, the District of Columbia and five U.S. territories, which can now begin attracting private investment capital from the estimated $6 trillion in capital gains that individuals and businesses left unrealized at the end of 2017.
Under the law, investments in the form of business profits, publicly traded stock or appreciated property are to be pooled into Opportunity Funds (O Funds) organized as corporations and partnerships, and authorized by the Treasury to invest at least 90 percent of its assets in OZ businesses. For example, a fund may be earmarked to renovate existing commercial real estate or build new developments in an OZ, or a fund may focus on supporting the expansion of existing businesses in the OZ or incentivizing new businesses to open there. O Funds are similar to mutual funds, stock portfolios or other vehicles for which individuals expect a return on the capital they invest in the fund. However, investors in OZs receive economic benefits in the form of tax incentives and the more esoteric advantage of helping to improve the local community.
The Tax Benefits Available to Opportunity Zone Investors
In return for their capital, businesses and individuals may receive the following federal tax benefits when they roll over their unrealized capital gains from business and real estate investments into Opportunity Zone Funds:
- Temporarily defer tax on reinvested capital gains until Dec. 31, 2026, or the date the opportunity zone fund sells the investment, whichever occurs sooner;
- Permanently remove/exclude from taxable income the capital gains yielded from the sale or exchange of an investment in a qualified opportunity zone fund that investors held for a minimum of 10 years;
- Receive a step-up in the basis of an original investment by 10 percent when the taxpayer holds the investment in an opportunity zone fund for at least five years, and by an additional 5 percent when the investment is held for at least seven years, excluding up to 15 percent of the original gain from taxation.
The value of this preferential tax treatment is based on the amount of time the taxpayer holds his or her investment in the O Fund. The longer the holding period, the greater the tax benefit. Therefore, an investor could conceivably roll over into an O Fund the capital gains he or she earns from a stock portfolio, a mutual fund or the sale of highly appreciable property, such as real estate, and avoid capital gain tax when he or she holds onto the O Fund for 10 years. A more modest tax benefit is available when the holding period is between five and seven years.
As simple as this may sound, it is important to remember that the Investing in Opportunities Act is a part of the federal tax code and therefore requires taxpayers to meet certain criteria to realize the potential tax benefit. For example, capital gains must apply only to sales between unrelated parties. A developer who sells property A that he or she owns cannot defer tax when he or she reinvests the capital gains into property B that the developer, a member of his or her family or a subsidiary of its business owns. In addition, the reinvestment of capital into an OZ fund must be made within 180 days from the date the taxpayer realized the taxable gain. Moreover, investors must understand the rules guiding what qualifies as an equity investment eligible for reinvestment in an OZ for federal tax purposes. For example, eligible investments in real estate are limited to a taxpayer’s ownership interest in new construction or assets that will be improved substantially within 30 months of acquisition by the O Fund.
Individuals who own, invest in or develop commercial real estate in OZs can receive the added benefit of local tax incentives when their property is located in empowerment zones, community redevelopment agency (CRA) districts or other underserved neighborhoods that rely on public and public-private dollars to support job creation, affordable housing and business development. The challenge, for individuals and businesses is to understand how the creation of O Funds and investment in OZs can fit into a larger tax strategy and allow taxpayers to leverage these vehicles to maximum tax savings.
While final guidance on the application of the new law is pending release from the U.S. Treasury, taxpayers should meet with their advisors and accountant now to begin planning for the establishment and seeding of O Funds. The earlier one begins planning, the more prepared he or she will be to pull the trigger and rollover unrealized gains to receive the benefit of the law’s preferential capital gain treatment.
About the Author: Edward N. Cooper, CPA, is director-in-charge of Tax Services with Berkowitz Pollack Brant, where he provides business- and tax-consulting services to real estate entities, multi-national companies, investment funds and high-net-worth individuals. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
Included in Florida’s budget for fiscal year 2018 is an expansion of the state’s Sales Tax Credit Scholarship Program. Under the program, eligible businesses may receive a tax credit when they redirect their sales tax on commercial real estate leases to approved organizations that fund scholarships and job-training programs for eligible students throughout the state. The Department of Revenue (DOR) has already begun accepting applications from businesses, for which the state will allocate $57 million in available credits.
Tenants that occupy, use or are entitled to use commercial property may apply to the state to receive a dollar-for-dollar credit against the real estate rental tax they paid to a landlord when they make monetary contributions to an eligible scholarship-fund organization in the state that is exempt from federal income tax. Eligible organizations may include scholarship-funding organizations, such as Step Up For Students and Gardner Scholarships; private schools with students in grades K through 12; and accredited facilities that provide job-training services to persons who have low income, workplace disadvantages or other barriers to employment.
Timing is critical for businesses that wish to apply to allocate their tax credits to qualifying scholarship-funding organizations. While the DOR expects to receive numerous applications, it will allocate the $57 million in available credits on a first-come-first-served basis. Upon the DOR’s approval of an application, the agency will send a certificate of contribution to the business’s landlord, who will then reduce the tax that he or she collects from the business’s lease payments beginning on October 1, 2018.
With advance planning under the direction of experienced state and local tax advisors, businesses that pay commercial rent can apply to the Florida Sales Tax Credit Scholarship Program and realize potential tax savings while helping underprivileged children get the education they deserve.
About the Author: Karen A. Lake, CPA, is SALT (state and local tax) specialist and an associate director of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses navigate complex federal, state and local tax laws, and credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
About the Author: Karen A. Lake, CPA, is SALT (state and local tax) specialist and an associate director of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses navigate complex federal, state and local tax laws, and credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Taxpayers have until Sept. 28, 2018, to avoid criminal prosecution and steep penalties when they coming forward voluntarily and share with the IRS previously undisclosed foreign financial assets. The IRS announced that on that date it will end the Offshore Voluntary Disclosure Program (OVDP) that it implemented to encourage reticent taxpayers to come into compliance with U.S. laws and pay their fair share of U.S. taxes.
The IRS first introduced an OVDP in 2009 to allow noncompliant taxpayers to come forward voluntarily to resolve their unreported income and assets. Consequently, more than 56,000 taxpayers have participated in the program and paid taxes, interest and penalties in excess of $11 billion. The agency reissued and updated the program several times, as recently as 2014, when the penalty for unreported assets held in certain foreign financial institutions investigated by the Justice Department was substantially increased.
Eligible taxpayers who unwillingly and unintentionally failed to disclose their foreign income and foreign assets may continue to use the Streamlined Filing Compliance Procedures (SFCP) as well as Delinquent International Information Return and Delinquent Foreign Bank and Financial Account (FBAR) Filing Procedures to meet their tax reporting obligations. For now, these programs remain in effect indefinitely. However, the IRS may choose to terminate them at any time.
The advisors and accountants with Berkowitz Pollack Brant work with domestic and foreign individuals and businesses to comply with international tax laws, maximize tax efficiency and reduce unnecessary compliance costs.
About the Author: Arthur Dichter, JD, is a director of International Tax Services with Berkowitz Pollack Brant, where he works with multi-national businesses and high-net worth foreign individuals to structure their assets and build wealth in compliance with U.S. and foreign income, estate and gift tax laws. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
Despite governmental efforts to repeal or limit taxpayer use of 1031 exchanges, a robust real estate market is continuing to drive demand for this powerful tax-planning tool. Under Section 1031 of the Internal Revenue Code, individuals may defer taxes on the sale of certain commercial real estate property when they reinvest the profits into new, similar property of equal or greater value. Essentially, money that taxpayers would have paid to cover taxes on the gain from a sale of one asset are instead reinvested in a similar asset, or assets, and treated by the IRS as a reinvestment of capital that is not subject to taxation. As a result, taxpayers may sell a long-held, low-tax-basis investment property that has appreciated in value without incurring significant federal and state income taxes, and they may change the form of the “like-kind” asset to allow their original investment dollars to continue to grow tax-free.
Yet, taking advantage of 1031 exchanges requires careful planning and understanding of a complex set of rules.
Definition of Like-Kind Property
To qualify for 1031 treatment, both the real estate sold and the real estate acquired must be “held for either productive use in a trade or business or for investment.” Because the law requires the properties for exchange to be of similar nature but not of the same quality, investors, developers or builders may swap a residential condo building for an office building or a retail complex for unimproved land. They may also exchange investment property for real estate used in their business or trade.
The Importance of Intent
To determine whether a transaction qualifies for 1031 treatment, the IRS looks at the property holder’s intent to use the real estate in a trade or business or for investment purposes by considering the following factors:
Frequency of Taxpayer’s Real Estate Transactions
The tax code allows taxpayers to engage in multiple 1031 exchanges in a year. However, the more property sales a taxpayer has, the more likely the IRS will consider he or she to be real estate “dealers” who must hold assets for sale. In most cases, this restriction will not meet the qualified-use test required for 1031 treatment.
Taxpayer’s Development Activity
A property may be disqualified from 1031 treatment when the taxpayer makes efforts to improve the asset through the addition of utility services, roads or other activities that can influence the gain on the sale of the property.
Taxpayer’s Efforts to Sell the Property
The IRS looks at the amount of time, effort and involvement a taxpayer expends to control the sale of property to determine the applicability of a 1031 exchange.
Length of Time Taxpayer Holds the Property
While there are no specific rules detailing how long a taxpayer must hold real estate for investment or business purposes to qualify for a 1031 exchange, the IRS generally accepts a period of two years. “Flippers” and other investors who purchase a property immediately prior to a 1031 sale or who sell a property soon after a 1031 transaction can be disqualified from claiming the benefit of tax deferral.
Purpose for which Taxpayer Holds the Property
The IRS considers the purpose for which the property is held at the time of sale to determine application of 1031 exchange tax benefits. The purpose for which the property was originally acquired may have no influence on the decision. Therefore, a developer may purchase raw land with the intent to build single-family homes and then, later build rental units or sell portions of the land. Similarly, a homeowner who purchases a primary residence may later decide to rent out the home for investment purposes and subsequently sell the property as part of a 1031 exchange.
The Tax Cuts and Jobs Act that overhauls the U.S. Tax Code beginning in 2018 preserves the use of 1031 exchanges to help investors extend the value of their real estate holdings. Yet, the tax code remains a complicated maze of provisions for which individuals should meet with tax professionals to assess relevant planning opportunities and take advantage of their ability to reinvest profits rather than paying capital gains tax.
About the Author: John G. Ebenger, CPA, is a director in the Real Estate Tax Services practice of Berkowitz Pollack Brant, where he works closely with developers, landholders, investment funds and other real estate professionals as well as high-net-worth entrepreneurs with complex holdings. He can be reached in the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at jebenger@bpbcpa.com.
In matters in which the IRS determines that a taxpayer is deficient in meeting his or her income tax liabilities, it is generally presumed that agency is correct. It is the taxpayer who bears the burden to prove the IRS wrong by a preponderance of evidence. In essence, the IRS can challenge any and all taxpayer claims to credits and deductions, even if the taxpayer is in fact entitled to them. Taxpayers must then show demonstrative proof to back up the tax treatment for which they claim they are entitled.
This was the issue before the U.S. Tax Court in February 2018 when the IRS challenged a Mississippi family’s deduction of $27,646 in expenses incurred to replace carpeting and make other routine maintenance repairs to rental units in real estate property that the family owned. The IRS issued the taxpayer a notice of tax deficiency and a related penalty contending that those repairs constituted a property “improvement” that the taxpayer should have written off and depreciated over time. The only proof that the taxpayer presented to prove that it properly deducted those expenses was a three-page list of its itemized repairs and associated costs.
The court subsequently ruled in favor of the IRS due to the taxpayer’s inability to meet its burden of proof and provide a preponderance of documents, records and other physical evidence to counter the IRS’s claim.
What could the taxpayer have done differently? According to the court, the taxpayer could have corroborated its position with records documenting the value of its properties before and after the repairs through appraisals, or inspection reports or lease contracts that stipulate the taxpayer’s requirement to make repairs in between tenants.
In light of the court’s decision, it behooves taxpayers to err on the side of caution and take extraordinary steps to prove their decisions to claim deductions, especially with regard to real property and the repair regulations. As a minimum, taxpayers should take before and after photographs and/or video of items that require repairs in order to demonstrate that the costs they incur are in fact a result of general property maintenance and not improvements, restorations and betterments to extend the property’s useful life or adapt it for a new or different use.
About the Author: Arthur Lieberman is a director in the Tax Services practice of Berkowitz Pollack Brant, where he works with real estate companies and closely held businesses on deal structuring, tax planning, tax research, tax controversies and compliance issues. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
