Qualified Opportunity Zones & Qualified funds to defer your gain

12 Replies

I was doing a research for a customer and realized Bp community can also benefit from this. I personally believe, Qualified Opportunity zones almost as effective as 1031 exchange.  Trying to keep this simple and just the basics.  We are still waiting on some technical correction and clarification. 

The Tax Cuts and Jobs Act allows

A) Temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund (QO Fund) and

B) Permanent exclusion of certain capital gains from the sale or exchange of an investment in the QO Fund.

A) Temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund (QO Fund) 

Important points:

● No dollar limits

● Have to reinvest the capital gain within the 180 days

Have to include the excluded gain (reinvested gain) at the end of the deferral period which includes earlier of:

○ The date on which the investment is sold

○ Dec 31. 2026

● What gain is included? See example below.

○ Excess of (formula = Initial reinvested gain – basis of investment)

■ Gain excluded when reinvested in QO fund (or FMV of investment if lower) over

■ Basis in the investment.

○ Basis starts with Zero and increases in this order

■ Held for 5 years - 10% of gain reinvested

■ Held for 7 years - 15% of gain reinvested

■ Held for 10 years - 100% of gain reinvested

Thus, if held for 10-year, total capital gain that was reinvested is permanently deferred.

B) Permanent exclusion of certain capital gains from the sale or exchange of an investment in the QO Fund.

● If the investment is held for 10 years, the capital gain on the sale of the investment is excluded.

What is QO fund:

Corporation or partnership that invests in QO zone property that holds 90% of its asset in the QO zone.

A QO Zone property is property is:

● Domestic Stock

● Partnership interest

● Business property used in trade or business

Example:

A sells a property and realizes a gain of $1 million on Dec. 1, 2021. On Dec. 31, 2021 (i.e., a date within the 180-day period beginning on Dec. 1, 2021), A invests all of the $1 million gains in a QO Fund. If A makes the temporary deferral election, A does not include the $1 million of realized gain in his gross income for the 2021 tax year.

If A holds (Not sold) the investment in the QO Fund until Dec. 31, 2026, as the deferral period is over, A has to include the deferred gain in A’s gross income in 2026.

How much of the reinvested $1M would he include? Answer: 900,000

● Reinvestment amount = $1M

● Basis increase = 100,000 (10% of Reinvestment as held for 5 years.)

● Gain included = (Reinvested amount - basis increase) = 1M - 100,000= $900,000.

If A also sells the investment in QO Fund on Dec 1, 2031, 10 years later, he does not recognize any capital gain on the sale of his investment in QO fund.

If A sells the investment before 10 years, basis in the investment is based on the time it is sold:

Basis starts with Zero and increases in this order

■ Held for 5 years - 10% of gain reinvested

■ Held for 7 years - 15% of gain reinvested

Basis at 5 years = 100,000

Basis at 7 years = 150,000

Thus gain/loss is determined based on the FMV of the investment less the basis at the date of sale. If a date of sale was more than 10 later the initial investment, no capital gain is recognized.

It's also important to note that according to Sec 1400Z-2 (D) the property must be used in a trade or a business. The investor must start or have an "original use" of the property, which most likely means the investor will have to start a new business on the property or get a tenant that is starting a new business.

If the investor is purchasing a property that already has a business on it and chooses to either buy and continue that business or continue renting out the property to that existing business, they then have a 30 month period over which they must invest an amount that exceeds the adjusted basis at the beginning of the 30 month period for "substantial improvements". So for example, an investor buys a storefront property with a tenant in it for $500,000, continues to rent it to that tenant for a year and then decides to start his 30 month investment. Let's say the adjusted basis of the property is now $600,000. The investor now has 30 months to make at least $600,000 worth of improvements to the property.

Another factor to consider is that some businesses are disallowed, not unlike NMTC eligibility. For example an investor cannot have a business on the property that engages in any of the following “sin” businesses: any 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.

With these factors in mind, I would think caution would be in order for any investor looking to defer taxes through this program. There are still many gray areas for which the Treasury and IRS have not made clear regarding documenting and guaranteeing that the actual deferrals, cost basis reductions and permanent exclusions will be honored in any given business and property combination.

This alone has tempered my interest in Opportunity Zones. To think of what types of businesses and which specific areas within the LICs designated that could actually help defer investors CG taxes without actually becoming a loss seems daunting. 

I feel the only way to success would really be to devote oneself to the altruistic intent of the Opportunity Zones program by making meaningful connections to the community and learning what the biggest needs are, finding sponsors or organizations willing to run a business for profit or non-profit that would really be accepted and welcomed by the community. Partner with them to acquire an acceptable property within the designated areas that would house that business or organization.

It would require a lot of time and work, but would probably be the best way to avoid losing money on a property that would house a failing business or worse yet sit vacant and cause further blight to these already struggling communities.

@Stan Kaneshige

Thanks for the input. 

The good thing about QO fund is that there are many organizations that will take care of investing in a right property. There are many Qualified Intermediaries for 1031 exchanges that are creating a number of partnerships just to invest in these opportunity zones, so the investor would reinvest their gain via them on whatever asset they are comfortable with.  

This will be just as a partnership that is investing in a Conservation Easement. The partnership will take care of all the details and investors will just choose what they want to invest in. 

Also, the substantial improvement is what makes this incentive so good. If a QO fund invests in a land/old apartment that was already an investment property, and If it cost 250,000 to buy land/old apartment, you need to spend additional 250,000 within 30 days on the project, you dont have to complete the entire project or built an apartment. Spending $250,000 to value-add/addition to an old apartment or built new apartment is very doable. 

I am excited to see how all these folds. 

If apartments are allowed as “business property” that would make this program more attractive. I have inquired to the EIG regarding this but did not receive an answer. Have you found any definitive clarity on this, hopefully citing  code or some type of similar precedence with NMTCs that might lend to apartments or residential housing units being accepted by the IRS as business property? 

It is true that the code in 1400Z-2 says "business property" as opposed to "commercial property". But from everything I have read, it seems the code is excluding any form of residential housing, whether single or multi. So if an investor were to purchase an SFH in one of these mixed use OZs, could they run a Day Care in it for the duration of the investment, fulfilling the "new business or trade" requirement and then try to exit after 10 years, marketing it as a rehabbed SFH? What about properties not zoned "mixed" but straight "residential"?

I think once the Treasury Dept and/or IRS releases clearer directions on these types of situations and whether they will be recognized or not as making a Fund qualified for OP Tax breaks, there may be as you say many qualified organizations putting together funds. How much those organizations will be charging investors, along with how much investors will trust these Fund runners over the course of 10 years with their money will be very interesting to watch. 

I thought one of the more surprising aspects is the self certification for the QOF vehicle (partnership, corp, etcJ. This would allow an investor to technically avoid having to trust an outside entity with his CG funds for 10 years, if his strategy were to maximize the benefits.

@Stan Kaneshige , my firm is a member of a working party group which is working with Congress for the needed clarifications.  QOZs do indeed include all forms of commercial real estate provided it is either new construction or meets the “substantial improvement” qualification (double the basis).  Note that these investments must be made through a Qualified Opportunity Zone Fund. 

@Drew Reynolds Nice to meet you and thank you for the contact request!

So has your group confirmed that apartments or MFH in residential zones will or will not qualify as a "business property" in regards to satisfying requirements 1400Z-2? Can a developer build brand new apartment buildings in commercial zones and qualify? 

Because if it does I can see @Ashish Acharya 's point about some QOZ Funds focusing on buying land or existing apartments and renovating. I would imagine they would push the funds to sell after 10 years to get the permanent exclusion on the further gains if there are any.

Depending on the area I don't know how much of a long-term (past the 10 years) positive community impact that would provide as opposed to actually starting new businesses that encourage jobs, growth and revitalization.

As far as your concluding statement of how "these investments must be made through a Qualified Opportunity Zone Fund", that is my understanding as well. I just think it's a bit comical how there is no outside/governmental certification required. The IRS FAQ page states the following:

  • "To become a Qualified Opportunity Fund, an eligible taxpayer self certifies. (Thus, no approval or action by the IRS is required.) To self-certify, a taxpayer merely completes a form (which will be released in the summer of 2018) and attaches that form to the taxpayer’s federal income tax return for the taxable year. (The return must be filed timely, taking extensions into account.)"

Now obviously we will have to wait to see what is on that form to be released this summer, which is already here in LA :)

It makes it sound like anyone can start a Qualified Opportunity Fund. So investors send me your money! I'm Qualified!!! I can guarantee I will defer your Capital Gains!! Which property I can scrounge up in a designated Zone and how I manage that for you over 10 years - don't worry about that! Just pay me my fees up front and we are all good. lol

We are just beginning to see the very first QOF’s form, however there are not many yet. The U.S. Treasury Department and Internal Revenue Service are working on QOF guidelines and regulations. As of now, we understand that the IRS is allowing self-certification of Qualified Opportunity Funds. To self-certify, a taxpayer merely completes a form (which will be released in the summer of 2018), and attaches that form to the taxpayer’s federal income tax return for the taxable year. Consequently, no approval or action by the IRS is required to certify a taxpayer. The IRS also says it will provide more details and additional legal guidance over the next few months.

@Ashish Acharya

I don't believe you're correct on this one:

                    Held for 10 years - 100% of gain reinvested

                    Thus, if held for 10-year, total capital gain that was reinvested is permanently deferred.

My understanding is that the 10-yr applies to part B - step-up of basis for the investment inside the fund. The originally deferred gain will have to be recognized no later than 2016 (which is before 10 years anyway!). You can get a discount of 10-15% if you hold it for 5-7 years, but the rest of the deferred gain must be recognized. 

I don't think you get a permanent deferral with OZ, unless you follow-up with a 1031 - which may or may not be allowed in combination with OZ.

Originally posted by @Michael Plaks :

@Ashish Acharya

I don't believe you're correct on this one:

                    Held for 10 years - 100% of gain reinvested

                    Thus, if held for 10-year, total capital gain that was reinvested is permanently deferred.

My understanding is that the 10-yr applies to part B - step-up of basis for the investment inside the fund. The originally deferred gain will have to be recognized no later than 2016 (which is before 10 years anyway!). You can get a discount of 10-15% if you hold it for 5-7 years, but the rest of the deferred gain must be recognized. 

I don't think you get a permanent deferral with OZ, unless you follow-up with a 1031 - which may or may not be allowed in combination with OZ.

I know what you mean. I had to dig into the committee report. 

Committee Report says

The basis of an investment in a qualified opportunity zone fund immediately after its acquisition is zero. If the investment is held by the taxpayer for at least five years, the basis on the investment is increased by 10 percent of the deferred gain. If the investment is held by the taxpayer for at least seven years, the basis on the investment is increased by an additional five percent of the deferred gain. If the investment is held by the taxpayer until at least December 31, 2026, the basis in the investment increases by the remaining 85 percent of the deferred gain."


Few experts have written on this issue. What I extracted from their interpretation was, yes as Dec 31, 2026, is less than 10 years away for the most taxpayer if they do this right now and afterwards, the deadline is expected to be renewed for a taxpayer to fully take advantage of this provision.

Originally posted by @Ashish Acharya :
Originally posted by @Michael Plaks:

@Ashish Acharya

I don't believe you're correct on this one:

                    Held for 10 years - 100% of gain reinvested

                    Thus, if held for 10-year, total capital gain that was reinvested is permanently deferred.

My understanding is that the 10-yr applies to part B - step-up of basis for the investment inside the fund. The originally deferred gain will have to be recognized no later than 2016 (which is before 10 years anyway!). You can get a discount of 10-15% if you hold it for 5-7 years, but the rest of the deferred gain must be recognized. 

I don't think you get a permanent deferral with OZ, unless you follow-up with a 1031 - which may or may not be allowed in combination with OZ.

I know what you mean. I had to dig into the committee report. 

Committee Report says

The basis of an investment in a qualified opportunity zone fund immediately after its acquisition is zero. If the investment is held by the taxpayer for at least five years, the basis on the investment is increased by 10 percent of the deferred gain. If the investment is held by the taxpayer for at least seven years, the basis on the investment is increased by an additional five percent of the deferred gain. If the investment is held by the taxpayer until at least December 31, 2026, the basis in the investment increases by the remaining 85 percent of the deferred gain."

Yes, the basis increases by the remaining 85% because you pay tax on the 85%, not because it's deferred  :)

@Ashish Acharya all this sounds like an interesting opportunity and something I want to learn more about. Some questions- 

1. If I am somebody who doesn't know how to manage a business/apartment or rental property, can I use my money and invest in someone else's QO Fund? In addition, how will I be rest assured to get my money back after 5,7 or 10 years say? Is the money tied to a piece of collateral or business? 

2. If I decide to roll my cap gains into one of these QO Funds in a designated QOZ in year 2019. Am I allowed to roll my cap gains the next year into the same QO Fund or Zone. Or would I be required to choose a different fund/zone? 

3. As far as I know, there is not much clarity on what is considered a QOF. For example, what is limited or excluded, single family houses, MFH, apartments ect. Furthermore, could I purchase a single family home or MFH with my cap gains and rent it out in a QOZ. Some would say I am using my cap gains to spur the community by providing decent housing to low income families. What's the stipulation on this?

Appreciate all the help!  

Originally posted by @Michael Doherty :

@Ashish Acharya all this sounds like an interesting opportunity and something I want to learn more about. Some questions- 

1. If I am somebody who doesn't know how to manage a business/apartment or rental property, can I use my money and invest in someone else's QO Fund? In addition, how will I be rest assured to get my money back after 5,7 or 10 years say? Is the money tied to a piece of collateral or business? 

2. If I decide to roll my cap gains into one of these QO Funds in a designated QOZ in year 2019. Am I allowed to roll my cap gains the next year into the same QO Fund or Zone. Or would I be required to choose a different fund/zone? 

3. As far as I know, there is not much clarity on what is considered a QOF. For example, what is limited or excluded, single family houses, MFH, apartments ect. Furthermore, could I purchase a single family home or MFH with my cap gains and rent it out in a QOZ. Some would say I am using my cap gains to spur the community by providing decent housing to low income families. What's the stipulation on this?

Appreciate all the help!  

1) You would be investing as one of the partners in the fund, and you would sell your partnership interest when you want out. You dont have to manage the business or even the fund. The fund will have a partnership agreement to buy you out. The fund manager will clarify this for you. 

2) There are no restrictions on how much you can invest in and you can invest in two different years.  The partnership might be always looking for the capital so your contribution each year to the same partnership might be acceptable as additional capital That would question for who is managing the fund. 

3) The Regs have already clarified what qualifies. Very simply, If you are buying a Rental property that was already in the zone, you have to double the basis of the house(not land) via improvements. It is possible for a distressed property but might be a problem for assets that are bought not that distressed. There is a lot into this as you can expect. If you have significant gain, it would be worth to sit down with a professional. Good luck,