By Jeffrey Moss.
If you haven’t heard about the Opportunity Zone tax incentive yet, you will soon. The “Opportunity Zone” Program was created in the Tax Cuts and Jobs Act of 2017 with the creation of two new Tax Code Sections 1400Z-1 and 1400Z-2. The purpose of the Opportunity Zone Program is to encourage the investment of private capital into certain designated economically depressed areas throughout the United States that were designated as “Qualified Opportunity Zones” by each state.
The mechanism for investing in a Qualified Opportunity Zone is through a “Qualified Opportunity Fund.” As of the date this article is written, the IRS has not yet issued any regulations related to Qualified Opportunity Zones or Qualified Opportunity Funds and there are many unanswered questions. Regulations are anticipated soon. Notwithstanding that, investor groups and speculators are establishing the framework for creating Qualified Opportunity Funds (“QOF”) so that they will be primed to invest in businesses and properties located in Qualified Opportunity Zones (“QOZ”).
WHAT IS THE TAX BENEFIT TO INVESTING IN OPPORTUNITY FUNDS AND OPPORTUNITY ZONES?
This new tax incentive allows the seller of appreciated property to roll his gain into a Qualified Opportunity Fund and to obtain a temporary deferral of taxation depending upon the holding period of the investment. As currently written, IRC Section 1400Z-2 generally triggers taxable gain at the end of 2026 even if the investor has not sold the Qualified Opportunity Fund shares by then. The amount of gain that the investor would recognize in 2026 is 100% of the deferred gain if the investor has held the QOF investment less than five (5) years; is 90% of the deferred gain if the investor has held the QOF investment more than five (5) years, but less than seven (7) years; and is 85% of the deferred gain if the investor has held the QOF investment longer than seven (7) years. Section 1400Z-2 does exclude post-investment increases in value if an investor holds the QOF investment for at least ten (10) years, but note that 2026 is less than ten (10) years from now, so even if an QOF investment is held for ten (10) years, in most cases there will be some tax paid before then.
Mechanically, the way this works is when someone invests in a QOF, they take a basis of zero in the QOF but their basis increases by 10% of the deferred gain after five (5) years and an additional 5% of the deferred gain after seven (7) years.
It is believed that an investor who rolls over gain into a QOF investment and holds the investment for at least ten (10) years will receive a step-up in the basis of the QOF investment to its fair market value on the date the investor disposes of its investment. This step-up in basis potentially eliminates any gain which occurs after the investor acquires the investment. The net result is for QOF property held for more than ten (10) years, the investor has no post-investment appreciation but will still pay tax on 85% percent of the gain initially deferred by 2026.
It is believed that the gain exclusion and basis step-up apply only to investments in QOFs purchased with reinvested gain. Therefore, a person who desires to shift funds from a regular cash account into a QOZ Program will not obtain any tax benefit. Moreover, an investor that rolls in an asset with a basis, will find that only the gain deferred, but not the entire investment, will benefit from the ten (10) year holding period. Thus, the post-acquisition gain could still be partially taxable to the extent the taxpayer rolled basis into the QOF. The investor may also have other taxes to pay such as depreciation recapture.
It appears that the use of Qualified Opportunity Funds to invest in Qualified Opportunity Zones will create some tax benefit for some investors with deferred gain. However, there are plenty of complications related to basis and also other requirements related to the definition of a Qualified Opportunity Zone investment. One such limitation is that a QOF must make invest at least 90% of its assets into “qualified opportunity zone property.” Thus, Investments must be made into real estate or a trade or business operating in the Qualified Opportunity Zone. Notwithstanding that, certain types of businesses such as golf courses, country clubs, massage parlors, hot tub facilities, sun tan facilities, gambling facilities or liquor stores are not qualifying businesses and are not qualifying investments and a QOF cannot invest in those types of businesses.
If you want to know more about the pros and cons of QOZ and QOFs, please contact Jeffrey D. Moss at email@example.com or your Dawda Mann attorney.