Last year’s tax reform created a new Opportunity Zone program, which offers qualifying investors certain tax incentives aimed to spur investment in economically distressed areas. Treasury Secretary Steven Mnuchin has predicted that the Opportunity Zone program will create $100 billion in private capital that will be invested in designated opportunity zones.
The idea for Qualified Opportunity Zones grew out of a program sponsored by Senators Tim Scott, R-SC, and Corey Booker, D-NJ. The investment can be supercharged by pairing it with credits such as the Affordable Housing and Low Income Housing Credits, and the New Market Tax Credit.
The IRS issued proposed regulations on Oct. 19, 2018. The regulations on the whole appear very taxpayer-favorable. They answer a number of questions, while leaving others for later guidance. Still, the proposed regulations, which may be relied upon until final regulations are issued, appear likely to start moving significant sums of money into Qualified Opportunity Funds (QOFs) and then into Qualified Opportunity Zones (QOZs). However, stakeholders and practitioners are reporting that many questions remain. To that end, the Office of Information and Regulatory Affairs (OIRA), housed under the Office of Management and Budget (OMB), has announced that a second package of regulations and reporting requirements is expected to be completed by the end of this year.
Qualified Opportunity Zones
States may designate Qualified Opportunity Zones (QOZs) – population census tracts in low-income communities. A state may designate up to 25% of such tracts as QOZs, and smaller states may designate not less than 25 tracts. Over 8,000 QOZs have been designated by states. The law permits certain contiguous tracts that are not actually in a low-income community to be designated as part of the QOZ. In urban areas, many communities that are already being gentrified are adjacent to low-income areas and have been included as part of a QOZ. The QOZ designations have helped to attract further interest in utilizing QOZs. Under current law, QOZs must be designated by 2028. Click here to see Treasury’s web page listing QOZs.
Qualified Opportunity Funds
Taxation of eligible capital gains is deferred if a taxpayer invests an amount equal to the gain into a Qualified Opportunity Fund (QOF) during the 180-day period beginning on the date of the sale. The other proceeds from the sale need not be transferred to the QOF but may be. For capital gains allocated to an owner of a pass-through entity, the 180-period begins on the last day of the entity’s tax year. A QOF must be a partnership or a corporation. The proposed regulations clarify that an LLC taxed as a partnership also qualifies.
A QOF is required to hold at least 90% of its assets in QOZ property. The 90% threshold is tested twice a year. QOZ property is 1) QOZ business property or 2) an equity interest in a corporation or partnership that is a QOZ business.
A QOZ business must have substantially all of its assets in the QOZ. The proposed regulations define “substantially all” as at least 70%. Combining the 90% and the 70% tests, it would be possible to have a valid QOF with only 63% of its assets in a QOZ business.
Tax Savings for Real Estate Investors
The Opportunity Zone program generally established the following investor tax benefits:
- a temporary tax deferral for capital gains realized on the sale of appreciated assets and reinvested within 180 days in a qualified opportunity fund (QOF);
- the elimination of up to 15% of the tax on capital gains that are invested in a QOF and held at least seven years (10% if held only five years); and
- the permanent exclusion of gain on the QOF itself if the QOF investment is held for at least ten years.
Under current law, the deferral of tax on gain transferred to a QOF lasts until the earlier of the sale of the property or Dec. 31, 2026. The 2026 date may have been selected for budgetary reasons and it is possible that date could get extended by subsequent congressional action.
If the QOF investment is held for at least five years, 10% of the deferred gain is permanently excluded. If held for at least seven years, an additional 5% of the deferred gain is permanently excluded. However, with a 2026 end date, the gain would have to be rolled over into a QOF by December 31, 2019 to be able to meet the seven-year deadline by 2026. Also, if the property is not sold by 2026, the taxpayer will have to come up with a source to pay the tax due on the deferred gain with the 2026 tax return. This obligation should be kept in mind when deciding how to invest the proceeds on the sale of the property other than the deferred gain.
According to MCB Tax Partner, Phil Busenitz, “Qualified Opportunity Funds could be the next big thing in real estate investing. Many fund managers are putting together QOFs. Any investment should be evaluated on its own merits. If a particular QOF would be a good investment, then the tax benefits – the deferral of capital gains, the permanent exclusion of 15% of capital gains, and the exclusion of gains on the QOF itself – would make it a great investment.”
Additional Questions Remain
Although stakeholder feedback has been largely positive, stakeholders and practitioners have noted several areas where additional IRS guidance is needed. Particularly, uncertainties surrounding the application of the QOF penalty, tax treatment of the sale of a QOF asset, and clarity on the definition of qualified opportunity zone business property are reportedly among items circulating the tax community as needing further guidance.
After the IRS released the proposed regulations, Sen. Scott praised the guidance while also noting that it is incomplete. “The first set of rules released by the Treasury Department today reinforce that this will not be another bureaucratic process burdened by red tape, but rather a streamlined, efficient process that allows for investments to truly help communities in need,” Scott said.
The House’s top tax writer has urged stakeholders in a recent statement to provide feedback on the proposed regulations. Moreover, those comments should include “identifying any areas where additional technical guidance would be valuable in providing certainty to potential investors and project managers,” House Ways and Means Committee Chairman Kevin Brady, R-Tex., said. Final IRS regulations are expected by the end of the year.
MCB has been providing tax advice and accounting services to investment companies and the real estate industry for over 70 years. If you have questions about Qualified Opportunity Zones, contact a MCB Tax Advisor at 703-218-3600 or click here. To review our tax news articles, click here. To learn more about MCB’s tax practice and our tax experts, click here.