By Daniel Cullen, Peter R. Matejcak and Sukbae David Gong – Baker McKenzie
Late last year, Congress passed sweeping tax reform legislation, commonly known as the Tax Cuts and Jobs Act. Of the numerous changes that were made to the tax laws, many are now realizing the potential of investing in a “qualified opportunity zone” (QOZ), a sleeper provision that could provide tremendous opportunities for communities in need, real estate developers, sponsors and investors. Specifically, Sections 1400Z-1 and 1400Z-2 created a QOZ, which offers tax incentives to investors who are willing to invest in low-income neighborhoods or other economically distressed areas for the long term.
To take advantage of the tax benefits associated with a QOZ, an investor needs to invest the gain amount it realized from any sale or exchange of property (to or with an unrelated party) in an equity interest of a “qualified opportunity fund” (QOF) within 180 days. If structured and executed properly, investing in a QOZ (through a QOF) could provide three major tax benefits: (1) temporary deferral of capital gains reinvested, (2) a reduction of a portion of such reinvested capital gains through limited periodic basis bumps, and (3) elimination of tax on the appreciation (and depreciation recapture) arising after investing in the QOF, if held more than 10 years.
What Is a QOF? — The Basics and Lingo
A QOF is an investment vehicle organized as a corporation or a partnership for the purpose of investing in “qualified opportunity zone property” and that holds at least 90 percent of its assets in qualified opportunity zone property (the “90% Test”). The “90% Test” is applied by taking the average of the percentage of qualified opportunity zone property held by the QOF: (1) on the last day of the first six-month period of the taxable year of the QOF and (2) on the last day of the taxable year of the QOF. Penalties apply if a QOF fails to meet this test.
Qualified opportunity zone property means any of the following: (1) qualified opportunity zone stock, (2) qualified opportunity zone partnership interests, and (3) qualified opportunity zone business property. Broadly speaking, qualified opportunity zone stock and qualified opportunity zone partnership interests are equity interest in a corporation or a partnership whose only trade or business is a qualified opportunity zone business (discussed below) for substantially all of the QOF’s holding period for such interest.
“Qualified opportunity zone business property” is tangible property used in a trade or business of a QOF if (1) such property was acquired by the QOF by purchase from an unrelated party after December 31, 2017, (2) either the original use of such property in the QOZ commences with the QOF or the QOF “substantially improves” the property, and (3) during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ. For this purpose, the “substantial improvement” test will be met if, during any 30-month period after the QOF acquires such property, additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period. This rule essentially requires that improvement costs equal, or exceed, the QOF’s original acquisition cost.
An entity is a “qualified opportunity zone business” if (1) substantially all of the tangible property owned or leased by such entity is qualified opportunity zone business property (determined as if such owner were a QOF), (2) at least 50 percent of the total gross income of such entity is derived from the active conduct of such trade or business, (3) a substantial portion of the intangible property of such entity is used in the active conduct of such trade or business, (4) less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property (as defined in Section 1397C(e) such as stock, options, or partnership interests), and (5) such entity does not operate, or lease land to, certain businesses, such as a golf course, country club, massage parlor, or any store whose principal business is the sale of alcoholic beverages for consumption off premises.
The Tax Benefits
When an investor sells any appreciated asset (e.g., stocks, bonds or real estate), unless certain statutory exceptions apply, the sale is generally a taxable event and the investor will owe taxes on the capital gain realized. However, assuming that the investor reinvested its capital gain into a QOF that is and will be in compliance with the rules discussed above, the investor may be able to receive the following tax benefits:
First, in exchange for reinvesting capital gains in a QOF, the investor receives a temporary deferral of inclusion in taxable income of such capital gain amount. This deferred capital gain must be recognized on the earlier to occur of (1) the date on which the QOF investment is sold or exchanged, or (2) December 31, 2026.
Second, the investor in a QOF will receive a step-up in basis attributable to the capital gains reinvested in a QOF. Increased basis means that these amounts will be excluded from future taxation. The applicable basis in the deferred capital gain is increased: (1) by 10 percent if the investment in the QOF is held for at least five years, and (2) by an additional 5 percent (for a total of 15 percent) if the investment in the QOF is held for at least seven years.
Third, if the investor in a QOF holds such investment for at least 10 years, the capital gains associated with the sale or exchange of the investment in such QOF will be permanently excluded from taxable income. From a tax perspective, this is achieved through a step-up in basis: at the time of sale or exchange, the investor’s basis shall be equal to the fair market value of such investment on the date the investment is sold. This permanent exclusion only applies to appreciation (and depreciation recapture) subsequent to investment in the QOF and does not apply to the capital gains achieved prior to the investment in the QOF.
There are some noteworthy distinctions between tax deferral achieved via a Section 1031 like-kind exchange — another popular tax deferral tool — and reinvesting in a QOF. Most notably, only real estate qualifies for a Section 1031 like-kind exchange. On the other hand, gain from the sale of any property can qualify for reinvestment into a QOF. Additionally, in a Section 1031 like-kind exchange, a taxpayer must reinvest its original investment amount (i.e., principal) and capital gains within 180 days of the sale. In contrast, only the capital gains amount needs to be reinvested in a QOF, which could potentially provide a QOF investor with more liquidity upfront. Finally, unlike a Section 1031 like-kind exchange, which most often requires a qualified intermediary, a taxpayer may invest in a QOF directly without involving an intermediary.
QOF Investor’s Tax Benefits: An Example
Suppose Anna, an early investor in the “hottest tech-stock” (“HTS”), hit the jackpot with a very successful initial public offering: she sells her HTS portfolio with a basis of $50,000 to an unrelated party for $500,000. This leaves her with a $450,000 gain and potential tax liability of $90,000 (assuming a 20 percent long-term capital gains rate). After being inspired by the Real Assets Adviser,she decides to redirect her investments into real estate. Instead of paying tax on her gain, Anna invests the $450,000 into a QOF and holds her investment in the QOF for 10 years (until 2028). For the purpose of this example, we will assume that the QOF met all the requirements discussed above and remained in compliance throughout its holding period. Assuming she has not sold her investment in the QOF, Anna will recognize gain of $382,500 ($450,000 less 15 percent of $450,000 from basis step-up (i.e., $67,500)), leaving her with tax liability of $76,500 for the 2026 taxable year. Note, this is less than the $90,000 of tax she would have owed in 2018 (and the benefit is even greater when considering the time value of money as this lesser amount is paid eight years later). If the QOF sells its investment after 2028 for $700,000, Anna pays no tax on the $250,000 gain ($700,000 less $450,000 original investment) realized on the QOF investment. For the purpose of this example, we will assume that there is no depreciation recapture.
As Anna’s example illustrates, the tax benefits of investing in a QOF can be substantial. Without investing in a QOF, Anna would have owed $90,000 of taxes as of 2018. If invested in a QOF, and even if the QOF made no gains for eight years, Anna would owe $76,600 of taxes in 2026. If invested in a QOF and the QOF made roughly a 5.7 percent annual return, Anna would owe $76,600 of taxes in 2026 and no taxes on her $250,000 gain. By contrast, if Anna invested in stock that provided the same returns, she would have owed $90,000 of taxes in 2018, invested $360,000 of after-tax proceeds into the stock, would have had $200,000 of gain ($360,000 x 56 percent) in 2028, resulting in an additional tax of $40,000 (20 percent x $200,000) — a total of $130,000 in taxes. The table below summarizes the alternative scenarios; note the significant difference in total taxes paid and after-tax proceeds at the end of the investment period.
Designation of Opportunity Zones
The chief executive officer of each state has been tasked with nominating the census tracts to be designated as Opportunity Zones. Each state nominated accordingly, and as of July 9, 2018, the IRS issued Notice 2018-48, 2018–28 I.R.B. 9, which lists all population census tracts designated as QOZs for purposes of Sections 1400Z-1 and 1400Z-2.
Many sponsors, developers and investors are still digesting the new law on QOFs and QOZs. As Sections 1400Z-1 and 1400Z-2 were drafted over a relatively short time period, many unforeseen practical issues are being highlighted by commentators. For example, the testing period for the “90% Test” implies that a QOF must deploy its capital within six months. This is a relatively short and unrealistic runway for a real estate construction or rehabilitation project. Further, the law is silent on how to measure the 90 percent — by fair market value, tax basis, or original cost basis? Fortunately, the Treasury and IRS have broad authority to proscribe necessary regulations to advance Congressional intent under these rules — offering tax incentives to taxpayers with appreciated assets who are willing to harvest their gains and invest proceeds in economically depressed areas for the long term — so many of these issues are expected to be addressed in the near future.
QOFs represent significant opportunities for communities in need, developers and investors. Given the bullish run of the market and a U.S. economy in recent years that has created tremendous unrealized capital gain, QOFs should be able to attract much-needed capital for community development, while at the same time providing significant tax benefits to investors, if they are structured and executed properly.