Are you an investor with a recent realized gain? You may want to evaluate the risks and benefits of investing the gain in a Qualified Opportunity Zone (QOZ). Introduced as part of the Tax Cuts and Jobs Act of 2017, opportunity zones offer tax breaks to real estate investors who make long-term investments in low-income census tracks.
Let’s explore how the program works and the available tax benefits. After selling an appreciated asset, an investor generally has 180 days to move capital gains into a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle, organized as a corporation or partnership, that holds at least 90 percent of its assets in a Qualified Opportunity Zone Property (QOZP). Generally, a QOZP represents a stock or partnership interest in, or a direct investment in, a Qualified Opportunity Zone Business Property (QOZBP).
There are three primary tax benefits for investing capital gains into a QOF:
- Temporary Deferral on Initial Capital Gains Tax Payment – The capital gains tax owed on the reinvested capital gains is deferred until the QOF investment is sold or exchanged, or until December 31, 2026 (whichever comes first).
- Partial Exclusion of Initial Capital Gains Tax Liability – If the QOF investment is held for at least five years, there is a 10 percent exclusion of the deferred capital gain.
- Elimination of Future Capital Gains – If the QOF investment is held for at least 10 years, the investor has the potential to eliminate any tax owed on the appreciation of the QOF investment if the QOF investment is subsequently sold.
The program’s proposed regulations created several uncertainties and questions regarding the implementation of the program. After receiving feedback from the public, the U.S. Department of Treasury and Internal Revenue Service issued final regulations. The final regulations are comprehensive in nature and provide clarifications and modifications to the proposed regulations. Some of the key takeaways are as follows:
As a general rule, the program only allows deferral of capital gains that are subject to United States federal income tax. Ordinary income, such as money sitting in a savings account, does not qualify. The final regulations outline the type of gains eligible for deferral when reinvested into a QOF within a 180-day reinvestment period. The 180-day reinvestment timeline for each type of gains is as follows:
• Sales of business property: Gross Section 1231 gains for business or trade property held for more than one year (other than those recaptured and treated as ordinary income) can be invested in a QOF without regard to losses. The 180-day reinvestment timeframe begins on the date of the sale or exchange, as opposed to the last day of the taxable year.
• Installment sales: Gains from installment sales can be reinvested beginning on either the last day of the taxable year in which the gain would ordinarily be recognized, or the date each payment is received. As a result, a taxpayer who receives multiple payments throughout the year may elect to have multiple, separate 180-day reinvestment timeframes.
• Foreign investments: Non-resident aliens and foreign corporations can invest capital gains that are effectively connected to a U.S. trade or business. This includes gains on real estate assets that are taxed to non-residents and foreign corporations under the Foreign Investment in Real Property Tax Act (FIRPTA) rules.
• Pass-Through Entities: Partners in a partnership, shareholders of an S Corporation, and beneficiaries of estates and non-grantor trusts have the option to start the 180-day reinvestment timeframe on the same day as the entity’s 180-day reinvestment timeframe, the last day of the entity’s taxable year, or the due date of the entity’s tax return (without extension) for the taxable year of the gain.
• Regulated Investment Company (RIC) and Real Estate Investment Trust (REIT): The 180-day reinvestment timeframe begins at the end of the taxable year in which capital gain dividends would otherwise be recognized by the shareholder. However, the shareholder may elect to instead begin the 180-day period upon receipt of capital gains dividends from a RIC or REIT.
Any gain arising from an inclusion event (i.e., events that reduce direct equity interest in a QOF), such as the termination or change in classification of a QOF’s status or transfer by gift or divorce, is eligible for deferral into a new QOF. The inclusion event can represent all or only a portion of the initially deferred gain. The 180-day timeframe begins on the date of the inclusion event. A full list of events and additional rules can be found in the final regulations.
“Sin Business” Narrowly Permitted
The final regulations allow a QOZB to lease up to 5 percent of its property to any of the prohibited sin businesses, which include golf courses, country clubs, massage parlors, hot tub facilities, tanning salons, racetracks, gambling facilities and liquor stores. However, a QOZB may not engage directly in any of such sin businesses.
Original Use of Tangible Property
Original use commences when a QOF or QOZB places into service property in a QOZ for purposes of depreciation or amortization. For instance, a QOF that purchases raw land and constructs a new multi-family building can pass the original use test because there was no prior economic use for the land or materials. The final regulations include the following exceptions:
• Self-constructed: Tangible property manufactured, constructed or produced (rather than purchased) by a QOF or QOZB may qualify as QOZBP as long as construction occurred after December 31, 2017, with the intent to use it in a QOZ. Also, the materials, construction and production must all be considered zone business property.
• Vacant property: Property that has been vacant for one year may qualify as original use, but only if the property was vacant for one year prior to the designation of the QOZ and remains vacant through the date of purchase. Property that does not meet this requirement will qualify after three years. Furthermore, the final regulations define “vacant” property as “significantly unused,” or more than 80 percent of the building or land is not being used.
• Brownfield sites: The land and structures qualify as original use property as long as the QOF or QOZB invests enough to improve the safety standards for human health and the environment.
• Leased property: A lease between unrelated parties is generally presumed to be a market-rate release. State and local governments, as well as Indian tribal governments, will be exempt from market-rate requirements.
If the property is not original use and does not meet the above exceptions, it must be substantially improved in order to qualify.
Substantial Improvement Test
The final regulations modified the substantial improvement testing to mitigate the asset-by-asset approach in the proposed regulations. The following aggregation methods were added:
• Aggregation of property: QOFs and QOZBs are permitted to incorporate the cost of purchased original use assets that would otherwise qualify as QOZBP. The property must be located in the same QOZ and used in the same trade or business. It must also improve the functionality of non-original use of the property. For example, if a QOF intends to substantially improve a hotel, it may incorporate mattresses, bed frames, linens and other tangible property utilized in the hotel business.
• Aggregation of buildings: Two or more buildings within a single QOZ, or a series of abutting QOZs that are located on land described in a single deed, may be treated as a single property for purposes of the substantial improvement test.
The final regulations offer additional rules and expansions of previous safe harbors:
• 50 percent gross income: A QOZB is required to derive at least 50 percent of its total gross income from the active conduct of a trade or business within the QOZ. The 50 percent active conduct requirement is quantified with the addition of three safe harbors: (1) contractor or employee hours; (2) the amount of payments for services; and (3) gross income.
• Working capital safe harbor: The proposed regulations incorporated a safe harbor permitting a QOZB that acquired, constructed or substantially improved a QOZBP to treat cash or cash equivalents (with a term of 18 months or less) as a reasonable amount of working capital for up to 31 months. The final regulations state the property may benefit from an additional 31-month safe harbor, for a maximum of 62 months. To qualify for the 62-month safe harbor, the QOZB must receive multiple cash contributions and each contribution must be allocated in a 31-month spending plan. If government delays (i.e., approval of building permits, zoning changes, etc.) interfere with the spending plan, the time is halted until the delay is resolved. Also, a QOZB may receive an additional 24 months, if it is located in a zone identified as a disaster area.
• QOF 90 percent testing: A QOF must ensure that at least 90 percent of its assets are invested in the stock or partnership interest of a QOZB or invested directly into a QOZP. A measurement of assets must be conducted semi-annually, on the last day of the first six-month period (June 30) and the last day of the taxable year of the QOF (December 31), or the QOF will incur a penalty. Prior to the final regulations, investors questioned the possibility of meeting the testing requirements, especially given shifting assets and the varied taxable years of businesses. Under the final regulations, a business only needs to be considered a QOZB at the end of its respective tax year. Even if the business fails the test, it can take advantage of a one-time 6-month cure period.
The final regulations allow investors that hold QOF investments for at least 10 years to elect to exclude all gain from the sale of QOF, QOZB interests, and, most significantly, from assets held by QOZB partnerships and S corporations, with the exception of inventory sold in the ordinary course of business.
For more information about the opportunity zone program, visit the U.S. Treasury Department’s Opportunity Zone Resources web page.
2022 Notable Events and Proposed Legislation
On February 7, 2022, the Treasury Inspector General for Tax Administration released its recommendation for improved processes and procedures concerning compliance and reporting requirements.
On April 7, 2022, the Opportunity Zones Transparency, Extension and Improvement Act (“the Act”) was introduced in both the Senate and the House of Representatives. The legislation seeks to revive and maintain the intended incentive that would otherwise expire under statutory deadlines and expand information reporting requirements. The future of the Act is uncertain, but as with any legislation, investors will need to evaluate the specific proposals and how they might affect their investments and activities in the opportunity zone program.
Opportunity Zone Investing: Is it right for you?
Investments in the opportunity zone program isn’t just about seeking tax benefits – the guiding principle of the program is to bring much-needed investment capital to historically low-income communities and provide revitalization with a lasting impact. If you’re looking to participate, it’s best to read the final regulations in their entirety and consult with investment and tax professionals and to consider the risks and benefits.
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