Among the most discussed provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) are the tax incentives provided for investments in Qualified Opportunity Zones (QOZs). These generous tax incentives have not only drawn attention from tax professionals, but also from real estate professionals, hedge funds, private equity groups and, of course, taxpayers who have large realized or unrealized capital gains. In addition, the mainstream media has been running stories about the benefits of investing in Qualified Opportunity Zones.
Generally, the new provision provides that taxpayers can reinvest an amount equal to their capital gain into a Qualified Opportunity Zone fund. The tax benefits of making this investment include:
- The tax on the capital gain can be deferred until December 31, 2026
- If the QOZ fund is held for greater than 5 years, 10% of the deferred gain is permanently eliminated; if held greater than 7 years, an additional 5% of the deferred gain is permanently eliminated
- If the QOZ property is held for at least 10 years, the gain on the disposition of the QOZ property is excluded from taxation
Qualified Opportunity Zones FAQs
The Internal Revenue Service has issued guidance in regulations, revenue rulings, and on its website. However, as is common with any topic that receives significant attention before complete guidance is issued, there is a lot of misinformation being circulated. In this connection, it may be helpful to review a few questions that Withum’s Real Estate Group has been receiving from our clients and contacts.
1. In 2018, a taxpayer sold publicly traded stock for $1 million and has a long-term capital gain of $750,000. Does the taxpayer have to invest the full $1 million into a Qualified Opportunity Zone fund to receive the full deferral?
No, the taxpayer is only required to reinvest the amount of capital gain to achieve the deferral. For a taxpayer selling real estate, this is a major difference between deferring gain under the like-kind exchange provisions (Section 1031) and deferring using a QOZ fund. The like-kind provisions mandate that the full sales price of real estate be reinvested to maximize the amount of the deferral. The QOZ rules only require that the amount of the gain be reinvested. A taxpayer can keep an amount equal to the tax basis in the property sold.
2. A taxpayer is a 10% member in a limited liability company that is treated as a partnership for income tax purposes. The taxpayer is informed by the entity that it realized a capital gain in 2018 and the taxpayer’s share is $300,000. The entity further informs its members that it will not elect to reinvest the capital gain into a QOZ fund. Can the taxpayer elect to reinvest the share of the capital gain into a QOZ fund and when does the 180-day period begin?
Under the recently issued regulations, an entity may elect to reinvest its capital gain into a QOZ fund. However, if the entity does not make the election, a taxpayer may elect to reinvest the allocable share of the capital gain into a QOZ fund. The regulations also provide that the taxpayer’s 180-day period to make any reinvestment begins on the last day of the entity’s taxable year.
This is a very generous rule, since many limited partners do not receive information about their allocable share of capital gains until after year-end. Taxpayers who receive this information before June 30 of the subsequent year will still have the ability to reinvest into a QOZ fund and defer their capital gain.
3. A taxpayer does not have a capital gain to defer but is interested in investing in a QOZ fund. Assuming the QOZ fund is held for over 10 years, can the taxpayer exclude the full gain on the disposition of the QOZ fund?
No, the exclusion of the full gain on the disposition of the QOZ property only applies to taxpayers who invest their capital gain into the QOZ property and make an election to defer the gain. A taxpayer who invests money into a QOZ fund without deferring any previous capital gain will not be eligible to exclude the gain on the disposition of the QOZ property.
4. Taxpayers who purchase a building in a QOZ must “substantially improve” the property for it to qualify as QOZ property. Substantial improvement is defined as additions to the basis of the property, during a 30-month period, in an amount that exceeds the basis of the property at the beginning of the 30-month period. This question relates to determining the basis at the beginning of the 30-month period. Must the taxpayer make additions that exceed the basis of the land and the building or just the building?
Again, the recent regulations make it clear that the amount of the additions to the basis of the property, during the 30-month period, only have to exceed the basis assigned to the building. The basis assigned to the land is not included in the computation.
A follow up question relates to how this rule applies to the purchase of vacant land in a QOZ. Must the land be “substantially improved” by making additions that exceed the basis of the land? The regulations only discuss the exclusion of the land basis when both land and building are purchased. It appears that, if only land is purchased, the substantial improvement provisions apply.
5. Taxpayers can also defer their capital gain if they invest an equivalent amount in a trade or business located in a QOZ. A taxpayer is contemplating opening a franchise for a retail store that sells liquor for consumption off premises. Assuming the trade or business meets the definition of a qualified opportunity zone business, will this qualify for deferral of the tax on the capital gain?
The franchise must meet certain tests to qualify as a QOZ business; these include a percentage of gross income derived from the trade or business and the location of property employed by the trade or business.
However, certain types of businesses are precluded from being QOZ trades or businesses. This includes country clubs, golf courses, gambling establishments, massage parlors and suntan facilities. Included in this list are retail stores with the principal business of selling liquor for consumption off premises. Therefore, the franchise will not qualify as a QOZ business.
Much more guidance has to be issued to address the uncertainties surrounding the tax benefits of investing in QOZ funds. The tax incentives are very lucrative and the lack of guidance may lead to liberal and possibly abusive interpretations.
Visit Withum’s Opportunity Zones Resource Center for more information about the tax benefits of investing in QOZs.
Join Withum’s Opportunity Zones experts on Monday, January 8th at 3:00pm, when they will discuss the latest proposed regulations and how this could impact you. Register here: Webinar: Opportunity Zones