Benefit From Opportunity Zone Investing
When party-goers dance into the new year on December 31st, 2019, investors with capital gains will be dancing to a different tune: they will be rushing to make investments in qualified opportunity funds (QOF) to get the ‘full’ benefit from the program.
The program will still be open for new investors after January 1st – see below for the details. Take care of your due diligence. It is more important than rushing to meet an incentive deadline and possibly ending up with a hasty investment. Investors have two years left to invest in a QOF.
AFTER JANUARY THE 1ST THE CREDIT FOR DEFERRED CAPITAL GAINS FOR QOF INVESTMENTS HELD FOR SEVEN YEARS GOES DOWN FROM 15% TO 10%
By rolling capital gains into a QOF, you incur lots of benefits: The trade-off lies between a few percentage points in tax savings and taking your time to find the perfect fund, project and zone. The act provides the opportunity to benefit from substantial tax savings if you invest in opportunity zone funds, but it also makes it possible to invest in, and operate businesses located in more than 8,700 qualified opportunity zones across 50 states.
⇒ You are free from capital gains taxes on your money until 2026.
⇒ When you become liable for capital gains taxes in 2026, the rate goes down by 15% (or 10% of you invested after January the 1st).
⇒ If the fund holds the asset, you invested in for a minimum of ten years, you will qualify for a zero-rate in capital gains when that asset is sold pone day.
In fact, opportunity zones allow investors to put the government’s dollars to work by helping entrepreneurs and job creators to make their dreams come true.
If you own appreciated assets in the form of stocks, art, a residence or a business – albeit as an individual owner, C corporation, partnership, S corporation or trust, and if you are interested in making a long-term investment, or starting an enterprise, then this is for you.
These are the front-end benefits:
⇒ Defer your capital gains tax until 2026.
⇒ Reduce the rate of capital gains tax you eventually pay after 2026 if you invested before January the 1st 2020, by 15%.
On the back-end:
⇒ You will acquire an asset that will most likely increase in value.
⇒ If you hold that investment asset for ten years or longer, you will pay ZERO TAX on the sale of the asset.
Precautionary Note
California, North Carolina and Mississippi do not follow federal guidelines on opportunity zone investing!
Ready For Opportunity Zone Investing?
PRO
⇒ Lower your tax bills.
⇒ Help disadvantaged areas.
⇒ Defer and save taxes.
⇒ Opportunity zones are not found only in low-income areas.
CON
⇒ Commit to a long-term investment of ten years or longer.
⇒ Give up some control over your money.
⇒ Some opportunity zones are in very low-income areas.
Investment Choice For Opportunity Zone Investors
Invest In Real Estate Asset
- You can invest in a multifamily apartment complex in a designated zone, or a ground-up substantial rehab.
- A ground-up commercial development, or a hotel redevelopment, etc.
Invest In Operating Business
- It is quite a complicated process.
- It will require sophisticated advice from lawyers and advisors.
- You have to meet the tests required.
- It is about more than merely locating to an opportunity zone.
Opportunities Available
Invest In An Well- Established QOF
- Most investors follow this route.
- Due diligence of utmost importance.
- Do feasibility study and ongoing review of the fund.
- Who are the general partners that manage the fund?
- Who does the audit on the fund? It has to be a large and well-known firm.
- There are more than 150 Qualified Opportunity Funds by now
Form Your Own Fund
⇒ Is the money you have available, enough to start your own fund?
⇒ You need a top-tier law firm.
⇒ You need a top-tier tax advisor.
⇒ You need a top-tier advisor.
Start A Business In An Opportunity Zone
⇒ It can bring substantial tax benefits.
⇒ Make very sure you satisfy the tests for such a new business.
⇒ It must locate in a QOZ.
⇒ It must derive at least 50% of gross income from an active trade or business inside the OZ.
⇒ New regulations require that at least 50% of the services performed (hours) by employees and independent contractors take place inside the QOZ , OR, if the tangible property of the business that is in the QOZ and the management, operational functions performed for the company in the OZ are each necessary to generate 50-percent of the gross income of the trade or business.
Hidden Gems In The Federal Opportunity Zone Program
The OZ program is already making a p0ositive difference in underserved communities at both local and state levels. There are enormous opportunities for investors with capital gains, but the rules are complex.
The OZ program is sophisticated, but it is flexible filled with significant advantages for those in the know. A lot of the uncertainty over the program was addressed in Treasury’s latest Tranche II set of OZ regulations. It provides guidance for business operators, landlords, and real estate developers. It also elucidated the mechanics, the deadlines and holding periods that caused a lot of confusion.
Dysfunctional Partnerships
Partnerships are sometimes very complicated vehicles for investment. The more partners, the more opinions there are on every decision that has to be made, sometimes very divergent views cause rifts, and when the partners decide to split, the sale triggers gains for every partner (i.e. the remaining partners structure a 1031 transaction to roll their gain and equity into a commercial property) and a 1031 ties-up the capital for every partner. In such an event, sophisticated alternatives have to be investigated, such as splitting the property into ‘tenant in common’ interests followed by the liquidation of the partnership before any sale can take place.
Things are very different in the OZ program. Parties are allowed to sell their interests. If the partnership does not select OZ-treatment at the equity level, the gain will flow to the partners on their year-end Form K-1. Partners can choose to take their profit, or under the OZ program, to invest their benefit into a QOF within 180-days. The equity holders are separated, and everyone wins.
Entity Choice
S corps are very popular amongst business owners, but there is one significant disadvantage to it. When the company is sold, or one of the owners dies, the ‘inside’tax basis of assets held in the S corp retain their historic cost basis, and therefore a step-up is as a rule, not possible for buyers except if they make a 338(h)(10) election. The OZ program offers a solution for extracting assets stuck inside an S corp to prevent this trapped appreciation.
Four Year Replacement Window
Taxpayers who sell appreciated real estate are always under pressure. They need a special accommodator to escrow all proceeds from the sale, and they must identify replacement property within 45-days of the date of the sale. This means that the taxpayer must close on the replacement property within 180-days. It has ramifications. The taxpayer is often forced to overpay for the replacement property, or they end up with a property that is less than ideal.
The OZ program, on the other hand, will always give the taxpayer more time to make smart decisions. A taxpayer that reports a real estate gain on Form K-1 has 180-days after the year-end to invest in a qualified opportunity fund, and he will not have to identify the replacement property for years; it can provide real estate investors up to 48-months or more. The extra time makes it possible for the taxpayer to do a ground-up construction to build the ideal replacement property.
Also, OZ transactions only require investors to reinvest their capital gain from the original investment, not the entire proceeds, so they can pocket their original basis and ‘ordinary.’
Take Note: Gains from an OZ program reinvestment will be recognized in 2026 irrespective whether the replacement property is still held.
A 1031 structure for real estate disposition will be advantageous for residents of states that do not recognize the OZ program yet. This includes :
⇒ Arizona
⇒ California
⇒ Hawaii
⇒ Massachusetts
⇒ Minnesota
⇒ North Carolina
⇒ Pennsylvania
Leveraging
There are advantages to the way debt is treated in OZ regulations. When a QOF is formed as a partnership, the investor’s share of the mortgage or other liabilities is treated as a capital contribution (basis increase) insofar as the debts of the QOF has obligations that are allocated to the partners.
This basis increase makes it possible for QOF investors to claim the tax losses that flow through the entity. In terms of the clarified regulations, the debt layer is eligible for a full step-up to fair market value in year ten.
Operating Business
As we mentioned above, opportunity zones are by no means only for real estate investors. Businesses (QOZBs) can deploy funds under the working capital safe harbor rules to start, buy or move businesses into an OZ.
If you start a business inside a QOF, IRC Section 1202 (for small business stock or QSBS) provides tax exemptions for the types of companies that meet the various statutory criteria.
The QSBS rules are undoubtedly complicated. To begin, the taxpayer can form the QOZB as an LLC that is taxed as a partnership. It will be converted into a C corp after start-up losses are incurred. Taxpayers must carefully evaluate the impact of double taxation and the loss of a tax step-up to the buyer in a sale transaction before they elect to convert into a C corp.
If the entity is sold within five years of becoming a C corp, 100% of the tax gain can be excluded within specified limits. Not all states conform. California, for example, is prohibited. In most states, the OZ investor gets double tax planning benefits; 1202 will be operative within five years after formation. There is no OZ gain exemption under the QSBS rules, but the $10 million exempt gain and the possibility to exit after five years rather than ten, more than makes up for this.
Additional tax mitigation is also likely since many of the OZ census tracts fall into federal and state tax incentive programs that include:
⇒ Property tax
⇒ Payroll tax
⇒ Income tax
⇒ Government grants
⇒ Employee training programs
Opportunity Zones Types
Background On Opportunity Zones
⇒ Opportunity zones were created by the Tax Cuts and Jobs Act. Opportunity Zones are economic development tools driven by tax incentives that allow people to invest in distressed areas.
⇒ Its purpose is to drive economic development and job creation in distressed communities. Contiguous and low-income communities qualify as opportunity Zones once a state, the District of Columbia, or a US Territory nominated them, and the US Treasury certified the nomination.
⇒ At present, 8.764 communities across the US are certified as Qualified Opportunity Zones.
⇒ After the certification process, Congress designated all low-income communities in Puerto Rico as Qualified Opportunity Zones (QOZ).
⇒ A list of QOZs is available at IRS Notices 2018-48.
Opportunity Zones (OZ) offer tax advantages to both businesses and individuals. Investors can defer tax on capital gains for a while if they invest their profits in capital gains in Qualified Opportunity Funds. The deferment of taxes on a capital gain will last until the investor sells or exchanges the QOF Investment, or on December 26th, 2026, whichever comes first.
Tax Benefits Are Determined By How Long Investment Is Shield
Investment held for five years
The basis of the QOF investment increases by 10% of the deferred gain.
Investment held for seven years
The basis of the QOF investment increases by 15% of the deferred gain.
Investment held for ten years
The investor is now eligible to elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF is sold or exchanged.
Gains that become eligible to be deferred are called ‘eligible gains.’ Both capital gains and qualified 1231 gains qualify, if:
Eligible Gains
⇒ Recognized for federal income tax purposes before January 1st, 2027
⇒ They aren’t derived from a transaction with a related person.
⇒ The amount was invested timely in a QOF in exchange for an equity interest in the QOF – hence if it is a qualifying investment.
Taxpayers can claim the deferral on their federal income tax return for the year in which the gain would have been recognized if they did not defer it.
Qualified Opportunity Funds (QOF)
These are investment vehicles that file a federal income tax return as a partnership or corporate entity, and which is organized for the purpose of QOZ property investment, and which:
⇒ Self-certified as such by filing Form 8996 every year along with its federal income tax return. The form must be filed timely. Even LLCs that selected to be treated as a partnership or corporation for federal income tax purposes can organize as a QOF.
Qualified Opportunity Zone Property (QOZP)
QOZP is a QOF’s qualifying ownership interest in a corporation or partnership that operates a QOZ business in QOZ or specific tangible property of the QOF that is used in a business in the QOZ.
To be a qualifying ownership interest:
⇒ The interest must be acquired after December 31st, 2017, only in exchange for cash.
⇒ The corporation or partnership must be a QOZ business.
⇒ The corporation or partnership must be in a QOZ business for 90% of the period of holding that interest.
Qualified Opportunity Zone Business Property (QOZBP)
This is defined as tangible property in the QOZ purchased after 2017, which is used in a trade or business AND:
⇒ The original use of the property in the QOZ started with the QOF or QOZ business, OR,
⇒ The property was substantially improved by the QOF or QOZ business, AND,
⇒ During 90% of the period, the QOF or QOZ business held the property, generally speaking, at least 70% of the use of the property was in a QOZ.
Conditions
A QOZ business must earn at least 50% of its gross income from business activities within a QOZ – every single year. To meet this test, three safe harbors are available:
⇒ Half of the aggregate hours of services received by the business were performed in a QOZ.
⇒ Half of the aggregate amounts that the firm paid for services were performed in a QOZ.
⇒ The tangible property and necessary business functions to earn the income were located in a QOZ.
Also You Need To Know This
Biden’s capital gains hike could sweeten this tax break
The Biden Administration plans to raise capital gain taxes. If they do, it might just make Donald Trump’s most generous tax break more lucrative for those who can sail uncertain waters.
The threat
Biden wants to increase the capital gain tax rate to 39.6% for those earning more than $1 million, amongst other changes. Investors need a plan to keep their tax obligations in check, and one possible solution might be to invest in the roughly 8,700 opportunity zones all over the US.
If you develop a real estate or funding business in the low-income areas with qualified opportunity zones, you can avoid capital gains taxes after a decade. This benefit will now become a lot more potent if Biden’s rates go up.
It is an open question whether any of Biden’s plans will make it into law. The current administration might even target opportunity zones for incentive reforms. The mere possibility has chilled most efforts to raise money for funds trying to reap these benefits.
Biden’s proposals have tainted opportunity zones, but as soon as the administration pushes something through Congress that hikes rates, opportunity zones will become very attractive to investors.
Opportunity Zones were innovative features of President Trump’s 2017 TCJA. Investors can claim the incentives by selling appreciated assets and reinvesting the proceeds in opportunity zone properties. This allows for the deferral of capital gains taxes until 2026 and cancelation if the new investment is held for at least ten years.
Trump’s goal was to attract investment into areas desperate for economic development. Of course, critics say the rules are too loose to help the poor. According to the University of California at Berkeley, investors gravitated to zones that were already on the up.
Biden’s campaign indicated that they plan to reform these tax breaks to ensure some social benefit to the poor, but it was mute about its plans except for the proposition of improved transparency and control over the kinds of investments made in these opportunity zones.
The Question: Are you better off paying capital gains tax now rather than paying taxes on gains in 2026 at a higher rate?
Bidens other plans include limiting property investor’s most popular tax break. This might drive more investment to opportunity zones. Of course, the Democrats might target opportunity zone incentives too, and this is proving to be the conundrum.
With this administration, no one knows which changes will happen or if any changes to the opportunity zone program are on the cards.
Should I reduce my investment in a Qualified Opportunity Zone by $1 to fall under the $1 million cutoff Biden proposed for the higher rate?
According to Erik Hayden of Urban Catalyst, this might not get you out of paying the higher rate.
In the end, the opportunity zone program will remain lucrative. Remember, the opportunity zone program makes good deals great, but it won’t make bad deals good.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intended for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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