Qualified Opportunity Zone legislation was embedded in the Tax Cut and Jobs Act, signed into law on December 22, 2017. The intent of the legislation was to encourage investment and job creation in economically distressed communities by creating tax incentives or preferential tax treatment, for investment in areas so designated. Localities qualify as a QOZ after nomination by a state or the District of Columbia, and certification by Secretary of the Treasury/IRS. This article is designed as a short summary, rather than a comprehensive treatment, of QOZs and related entities.
The first set of QOZ designations were so designated on April 9, 2018. The full list of QOZs can be found in IRS Notices 2018-48 and 2019-42, as well as on maps which can be found with a search. In the interest of internet safety and security, we have not included a link to a map, though as of April 2020, there were more than 8600 designated QOZs in the U.S. and qualifying territories. Final regulations governing Opportunity Zone investments were issued by Treasury and the IRS under Section 1400Z-2 on January 13, 2020.
Since there can be significant tax benefit for investors, a number of QOZ funds have been put together. These are generally referred to as Qualified Opportunity Funds, or QOFs. Some are solid and others less so. If you are approached by a QOF syndicator, how do you evaluate the opportunity? We believe the best approach is to have a basic understanding of the tax benefits and their requirements, have some clarity regarding the QOF self-certification process, what qualifies as Opportunity Zone business assets, and have at least a basic understanding of the requirements for operating a business in a Qualified Opportunity Zone.
The basic process is that investor funds are raised, then utilized by developers, often in conjunction with debt, and then the redeveloped properties are sold or leased. In a best-case situation, investors experience a real return, plus tax benefits, real estate developers complete the project and do so profitably, redeveloped property is well-built, attractive, and available for use, and distressed communities are enhanced with a new look, new businesses, and many employment opportunities.
Investor Tax Benefits
QOF investors can accrue two primary benefits. One is the deferral of tax on prior eligible gain to the extent that such an amount is timely invested in a QOF. Second, if the investor holds the investment in the QOF for at least ten years, the investor is eligible to adjust the basis of the QOF investment to market value on the date the QOF investment is sold or exchanged.
Example: You bought 1000 shares of AAPL in September 2015 for $20,000. You sold 500 shares of Apple last Friday at $120, for a total of $60,000, and have realized long-term gain of $50,000. You have up to 180 days from date of transaction to invest any or all of this gain in a QOF, which must then invest its capital in QOZ property. QOZ property can include QOZ stock, QOZ partnership interest, or QOZ business property.
The gain on the sale of the AAPL shares which is invested in a QOF is then deferred until the earlier of the date you sell or exchange your QOF interest, or December 31, 2026. At that point, the gain included in income is the lesser of the deferred gain or the market value of the investment (less basis which is typically zero). Holding the QOF investment for five or more years can further reduce taxable gain. A QOF investment held for ten years or more, if you as investor choose, can get a step-up in basis to the market value of the investment on the date such investment is sold or exchanged. This negates taxable gain completely.
Of particular interest is that Section 1231 property qualifies for QOZ/QOF treatment. Section 1231 of the IRC describes depreciable and real property used in a trade or business and held for more than one year.
90% Investment Standard
QOFs are required to invest at least 90% of their assets in QOZ property. Ask questions. How do the managers of the QOF ascertain that they are continually 90% invested in QOZ property? How do they handle new incoming funds? What supporting documentation do they offer you as investor? Those are three good starter questions.
QOZ Business Property
Under the QOZ statute, tangible property must meet three requirements to qualify as QOZ business property. First, the property must be acquired from an unrelated party after 12/31/2017. Second, its original use in the QOZ must commence with the taxpayer or, the taxpayer must substantially improve the property. Third, during substantially all of the entity’s holding period of the property, substantially all its use must be in the QOZ. Ask questions. How does the promoter or syndicator assure these three requirements are met? Who are the examiners, auditors, or certification specialists, and what experience do they bring to the table?
There is so much more. QOFs can be good investments and can defer or negate gain. What’s required? QOF syndicators who understand the rules and are diligent in their adherence to the rules and to fund governance. QOZ property which meets the requirements. And last but very much not least, there needs to be experienced real estate developers, and legitimate economic opportunity, in order for a QOF investment to make sense. If and as you have questions, please reach out.