The 2017 Tax Cuts and Jobs Act enacted sections 1400Z-1 and 1400Z-2 to encourage growth and investment in designated distressed communities, now called qualified opportunity zones. This law provides relief to taxpayers who invest in businesses located within these zones (“Qualified Opportunity Zone Businesses” or “QOZBs”). Individuals or companies with taxable gains can create qualified opportunity funds, or “QOFs”, to execute these QOZB investments.
While opportunity zones have been a hot topic of conversation, QOF investors had minimal clarity to build upon until the April 2019 IRS guidance. Now, this guidance provided the much needed clarity to make opportunity zone investing an actionable strategy. With the appropriate financial structures well suited to adhere to the unique long-term holding requirements of the legislation, investors and operators can capitalize on what will likely be a multi-billion dollar expansion of the private equity markets, all of which will need to be placed into opportunity zones.
Why Should I Engage in Opportunity Zones?
Akin to the combined tax benefit of a 401(k) and a Roth IRA, an investment in one of the country’s 8,700 designated opportunity zones has the potential to be one of the most significant tax-benefited investments in the history of the U.S. tax code.
There are two main tax incentives encouraging investment in qualified opportunity zones:
1. Deferral of Inclusion. The first incentive is a deferral of inclusion in gross income of certain capital gain to the extent that a taxpayer elects to invest a corresponding amount in a QOF. Within this, section 1400Z-2 permanently excludes a portion of such deferred gain if the corresponding investment in the QOF is held for five or seven years.
2. Election to Exclude. The second incentive allows for the taxpayer to elect to exclude from gross income the post-acquisition capital gain on investments in the QOF held for at least 10 years.
Thus, this one-two combo of incentives is similar to both a 401(k) and Roth IRA, but in most cases has a much shorter holding period.
In deciding whether to invest in widely marketed institutional QOFs or create one’s own QOF, it is critical to understand the value inherent to the opportunity zone program. While the second round of IRS/Treasury guidance gave investors much needed clarity on how best to invest in opportunity zones, most QOFs in the market today were structured before this guidance was released. Meaning, these funds were structured predominantly as though the QOF in question would exist for 10-15 years. This is a potentially costly structure to the E: email@example.com Armanino LLP WE’VE ALL HEARD OF OPPORTUNITY ZONES: NOW HERE’S WHAT YOU NEED TO KNOW TO ENGAGE By: Gerry Clancy, Nick Gibbons, Michael Krueger and Brett Mlinarich July 18, 2019 Gerry Clancy E: firstname.lastname@example.org Armanino LLP Nick Gibbons Michael Krueger E: email@example.com Newmeyer & Dillion LLP Brett Mlinarich E: firstname.lastname@example.org Opportunity Real Estate Advisors investor. If a QOF triggers an inclusion event in Year 11 (the QOF pays off a preferred return), the investors in this QOF will be missing out on 18 years of the 29 years available. In dollar terms, a QOF that is sold in Year 11 will give up 75% to 85% of the tax-exempt wealth that can be created1 !
This is not a 10-year investment vehicle—this is the ability to create a generation of tax‐exempt wealth. Keep in mind, investors in QOFs can recapture up to 100% of their initial investment without penalty. If invested wisely, a QOF should be able to return the initial investment within 3 to 5 years and retain full ownership in the underlying assets. In other words, it makes little sense to sell in Year 10-20, if the investor has already been paid back and the QOF is appreciating tax-free while distributing dividends.
What Does it Take to Create and Maintain a QOF?
As mentioned, there are numerous challenges to creating and maintaining QOF status. It is important to have the right team in place. Every successful QOF will have to be legally curated, invest in sound qualified investments, and will be subject to stringent reporting requirements. Rather than syndicate one large QOF to address these needs and thereby dismiss the differences that exist between investors for risk, Opportunity Real Estate Advisors, Newmeyer & Dillion, and Armanino have formed a strategic partnership to offer these services. Together we provide legal, accounting, and real estate investment advisory as the one-stop-shop Custom QOF Solution in the opportunity zone marketplace.
Understanding All Pieces Involved
There are many intricate parts to Opportunity Zone investing. Let’s get you up to speed on the key components
A qualified opportunity zone (“QOZ”) is a population census tract that is a low-income community. There are over 8,700 QOZs throughout the country and in US territories (e.g. Puerto Rico is a QOZ). A nationwide opportunity zone map can be found here or you can search each state’s website for a state specific map.
A qualified opportunity fund (“QOF”) is an investment vehicle organized as a domestic corporation or a partnership (or LLC) for the purpose of investing in qualified opportunity zone property. A QOF must hold at least 90% of its assets in qualified opportunity zone property. The QOF must maintain its entity status within the state it is operating for the life of the entity. The 90% investment standard is determined by the average of the percentage of qualified opportunity zone property held in the QOF as measured on:
1. The last day of the first 6-month period of the tax year of the QOF, and
2. The last day of the tax year of the QOF.
QO Zone Property
Qualified opportunity zone property includes qualified opportunity zone stock, a qualified opportunity zone partnership interest, and qualified opportunity zone business property.
QO Zone Stock
Qualified opportunity zone stock is any stock of a domestic corporation that a QOF acquires after 2017. The corporation must be a qualified opportunity zone business (defined below) when the stock is purchased. The corporation must be organized for the purpose of being a qualified opportunity zone business. The corporation must qualify as a qualified opportunity zone business for substantially all of the time the QOF holds the stock.
QO Zone Partnership Interest
Qualified opportunity zone partnership interest is any capital or profits interest in a domestic partnership that a QOF acquires after 2017 in exchange for cash. The partnership must be a qualified opportunity zone business when the QOF acquires the interest. The partnership must be organized for the purpose of being a qualified opportunity zone business. The partnership must qualify as a qualified opportunity zone business for substantially all of the time the QOF holds the interest.
QO Zone Business Property
Qualified opportunity zone business property is tangible property that a QOF acquires after 2017 and uses in a trade or business and that satisfies both of the following tests:
1. The use of the property in the qualified opportunity zone originates with the QOF, or the QOF substantially improves the property.
2. During substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
To satisfy the test in (1) above, the QOF substantially improves property if, during any 30-month period beginning after the date of the acquisition of such property, additions to basis with respect to such property in the hands of the QOF are more than an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF.
QO Zone Business
A qualified opportunity zone business (“QOZB”) is a trade or business if substantially all of its owned or leased tangible property is qualified opportunity zone business property, defined above, and if the trade or business satisfies all of the following tests:
1. The business generates at least 50% of its total gross income from the active conduct of a qualifying trade or business.
2. The business uses a substantial part of its intangible property in the active conduct of any such business.
3. Less than 5% of the average of the total unadjusted basis of the property of the business is from nonqualified financial property.
4. The business is not a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Temporary Deferral of Gain
1. Gain on property sold to an unrelated person can be deferred for any portion of the gain invested in a QOF within 180 days. There is no dollar minimum or maximum limitation on the amount of gain that can be deferred under this rule.
2. The election applies only to capital gains reinvested in a QOF
3. Deferred until the earlier of
• Date on which investment in the QOF is sold or exchanged
• By December 31, 2026
4. Stepped up basis
• If investment is held for at least 5 years, its basis is increased by an amount equal to 10% of the gain temporarily deferred
• If investment is held for at least 7 years, the basis is increased by an additional 5% of the gain deferred
5. Temporary gain deferral election cannot be made for a sale or exchange if an election previously made with respect to the sale or exchange is in effect
• A second reinvestment in a QOF of any gains from the same sale or exchange does not qualify for the election
• An election can’t be made for any sale or exchange completed after 2026
Permanent Deferral of Gain
1. If a QOF is held for at least 10 years, post-acquisition capital gains can be permanently excluded upon disposition of the investment
• This is done through increasing the investment’s basis to its fair market value on the date the investment is sold or exchanged
• Permanent deferral election does not prevent the recognition of gain that was deferred under the temporary gain deferral election
2. Since it is not possible to hold the investment for 10 years prior to December 31, 2026, the permanent exclusion election only excludes gain in excess of the deferred gain (Only post-acquisition gains are excluded).
3. Only the QOF has to be held for 10 years (i.e. the QOF can acquire and sell the QZB and roll up the gains into another QZB investment within 12 months all the way to December 31, 2047!!!)
Examples on How It Works
In 2018, you sell for $11,000,000 publicly traded stock that you originally purchased for $1,000,000. Your capital gain amount is $10,000,000, but within 180 days of the trade date, you reinvest the $10,000,000 gain amount in a QOF in 2018. The results vary depending on how long you hold the QOF investment:
4 If the QOF is held for 5 years and sold in 2023 for $15,000,000, you include in 2023 taxable income:
+ $9,000,000 of the original $10,000,000 of capital gain from the 2018 sale, and
+ $5,000,000 of gain from the sale of the QOF investment.
4 If the QOF is held for 7 years and sold in 2026 for $17,000,000, you include in 2026 taxable income:
+ $8,500,000 of the original $10,000,000 of capital gain from the 2018 sale, and
+ $7,000,000 of gain from the sale of the QOF investment.
4 If the QOF is held for 10 years and sold in 2028 for $20,000,000 you would have already included $8,500,000 of the original $10,000,000 capital gain in your 2026 taxable income:
No gain is reported upon sale of the QOF investment in 2028. Overall exclusion of taxable gain in the amount of $10,500,000!