Opportunity May be Knocking for Real Estate and Other Investors Seeking Significant Tax Savings by Arkadiy (Eric) Green, CPA
Posted on October 24, 2018
The IRS and U.S. Treasury last week issued long-awaited guidance on a new tax break introduced by the Tax Cuts and Jobs Act (TCJA) that may provide real estate and other investors with significant tax savings. While the proposed regulations provide some clarity about the Opportunity Zone program and how it will be administered, many questions remain unanswered and will require further guidance from the IRS and the Treasury. As a result, it is critical that taxpayers tread very carefully with the counsel of experienced advisors and accountants.
What is the Opportunity Zone Program?
Congress created the Opportunity Zones program as an incentive to help revitalize distressed neighborhoods with private investment rather than federal spending dollars. Under the hurriedly drafted tax reform bill passed into law at the end of 2017, taxpayers may defer and potentially eliminate capital gains tax liabilities from the sale of certain assets when they reinvest those gains into predominantly low-income areas certified by the U.S. Treasury as Opportunity Zones (OZs).
The law makes it clear that taxpayers may not invest directly into businesses or development projects in OZs. Rather, they must direct their capital into Qualified Opportunity Funds (QOFs) organized as corporations and partnerships, which in turn must invest at least 90 percent of their assets, directly or indirectly, into qualified businesses and real estate assets located in designated OZs. The QOFs, which are already being created by developers, private equity firms and even nonprofits, are made up of a portfolio of buildings and businesses located in more than 8,700 census tracts across the country that the Treasury has certified as Opportunity Zones.
How can I Reap Tax Savings?
The tax benefits that come with investments in OZs are impressive and become even more significant the longer investors keep their interests in QOFs. Here’s generally how it works. An individual or business that incurs a capital gain from the sale of real estate, stock or any other property to an unrelated person may reinvest or “roll over” the proceeds from the sale (in an amount equal to the gain to be deferred) in a QOF within 180 days from the date of the initial sale, and receive the following benefits:
- Defer tax on the original capital gain until Dec. 31, 2026, or the date the taxpayer sells his or her interest in the QOF, whichever occurs first;
- Exclude from taxation up to 15 percent of the rolled-over capital gain by receiving a 10 percent step-up in the basis of the investment after holding the QOF investment for at least five years, and an additional 5 percent step-up after holding the QOF investment for at least seven years; and
- Avoid capital gains tax on the appreciation of QOF investments held for a minimum of 10 years by making an election to increase the basis of the QOF investment to the fair market value of the investment on the date they sell their interest in the QOF.
For example, consider an investor who sells a property and incurs a $1 million capital gain. If the investor rolls that gain into a QOF, he or she can defer paying taxes on that gain until 2026. If the investor holds the interest in QOF for seven years, he or she will be taxed on only 85 percent of the original gain, or $850,000, instead of $1 million. If the investor sells his or her interest in the QOF after 10 years, his or her basis increases, and he or she pays no tax on the appreciation of the QOF investment.
From an investor’s standpoint, qualified opportunity funds can be good alternatives to 1031 like-kind exchanges, especially if taxpayers have challenges satisfying the 1031 requirements to identify suitable replacement property within 45 days and close within 180 days. Also, because the new tax law limits the use of 1031 exchanges solely to real estate beginning in 2018, investing in QOFs may be the only way for some investors to defer paying tax on their capital gains until 2026.
Nevertheless, investors should recognize that QOFs are illiquid investments that yield the most rewards the longer investors hold onto them. Moreover, there is no guarantee that investments in distressed Opportunity Zones will appreciate in value. Therefore, investors seeking to capitalize on the tax-deferred treatment of gains invested into QOFs should be prepared to hold onto their QOF investments for a long-term and have other sources of liquidity available to them (e.g., to cover tax payments on the capital gains they will recognize in 2026).
The guidance issued by the Treasury and IRS on Oct. 19, 2018, is not a comprehensive list of rules that answer all of taxpayers’ questions concerning the Opportunity Zones program. In fact, the Treasury and the IRS are still working on additional guidance that is expected to address a number of other issues and questions posed by tax practitioners. Nonetheless, these proposed regulations provide some much-needed clarity regarding the requirements that taxpayers must meet in order to properly defer the recognition of gains by investing in QOFs, as well as certain requirements that corporations or partnerships must meet in order to qualify as a QOF. Taxpayers may now rely on these proposed regulations to help them implement tax-efficient planning strategies for the remainder of 2018 and into 2019. Following are some of the issues that the most recent government guidance addresses.
What Gains are Eligible for Tax Deferral?
Capital gains incurred from an actual or deemed sale or exchange of assets, or any other gains that are required to be included in a taxpayer’s computation of capital gain are eligible for deferral. Excluded are gains that arise from a sale or exchange of property with a related party (based on the 20 percent ownership rule).
Who Can Qualify for Tax Deferral?
Taxpayers that can elect tax-deferral benefits of the Opportunity Zone program include individual taxpayers, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), partnerships and certain other pass-through entities (including S corporation, decedents’ estates, and trusts). Partnerships may elect to defer all or part of their capital gain to the extent they make an eligible investment in a QOF. If a partnership does not elect to defer capital gain, its partners may elect their own deferral with respect to their distributive share of capital gain to the extent they make an eligible investment in a QOF. Similar rules apply to other pass-through entities (including S corporations, estates and trusts) and their shareholders and beneficiaries.
When does the 180-day Period Begin?
Taxpayers generally must roll over capital gains into a QOF within 180 days from the date of sale or exchange giving rise to the capital gain. The proposed regulations provide that, in certain circumstances, the 180-day clock does not start running until the date the ultimate taxpayer would be deemed to have recognized the gain. For example, the 180-day period for partners in partnerships and shareholders of S corporations generally begins on the last day of the entity’s taxable year. The proposed regulations, however, provide an alternative for situations in which the partner knows (or receives information) regarding both the date of the partnership’s capital gain and the partnership’s decision not to elect deferral of the gain, in which case the partner may choose to begin its own 180-day period on the same date as the start of the partnership’s 180-day period. Similar rules apply to other pass-through entities (including S corporations, estates and trusts) and their shareholders and beneficiaries.
What Qualifies as an Eligible Interest Investment in a QOF?
In order to defer capital gains tax under the Opportunity Zones program, taxpayers must own an eligible interest in a QOF, which is an equity interest issued by the QOF, including preferred stock or a partnership interest with special allocations. Specifically excluded from the definition of eligible interest investment are debt instruments, such as bonds, loans or other evidence of indebtedness, as well as deemed contributions of money due to increase in partner’s allocable share of partnership’s liabilities.
What is included in the Definition of Qualified Opportunity Zone Business Property?
A QOF must be an investment vehicle legally structured as a corporation or partnership in any of the 50 states, D.C. or five U.S. territories. It must invest at least 90 percent of its assets in qualified opportunity zone property (QOZ Property), which includes qualified opportunity zone business property (QOZ Business Property) and certain equity interests in operating subsidiaries (either corporations or partnerships) that satisfy certain additional QOZ business requirements.
QOZ Business Property is generally tangible property that the QOF purchased from an unrelated party after Dec. 31, 2017, and used in the QOFs trade or business (substantially all of the use of such property must be in a qualified opportunity zone). The original use of such property must begin with the QOF (e.g., new construction), or the QOF must make substantial improvements to the property within 30 months of the date of its acquisition.
By and large, for the “substantial improvement” requirement to be satisfied, additions to the basis of the purchased tangible property in the hands of the QOF must exceed an amount equal to the QOF’s adjusted basis of such property at the beginning of the 30-month period. Based upon IRS guidance, if a QOF purchases a building located on land wholly within a QOZ, substantial improvement to the purchased tangible property is measured by the QOF’s additions to the adjusted basis of the building (thus, the “original use” requirement is not applicable to the land and the QOF is not required to separately substantially improve the land on which the building is located).
The proposed regulations also establish a helpful “working capital” safe harbor for QOF investments in QOZ businesses that acquire, construct, or rehabilitate tangible business property used in a business operating in an opportunity zone. Under this safe harbor, a qualified opportunity zone business may hold cash or cash equivalents for a period of up to 31 months, if there is a written plan that identifies these working capital assets as held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is a written schedule showing that the working capital assets will be used within 31-months, and the business substantially complies with the schedule.
There’s no question that Opportunity Zones have the potential to yield immense tax benefits. However, since the regulations are complex and still evolving, investors and QOF sponsors will need to work closely with their tax and legal advisors to plan ahead and implement strategies that maintain compliance and maximize tax savings under application of the new law.
About the Author: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.
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.