Time to Zone In On Qualified Opportunity Funds

Audrey G. Young
Of Counsel, Trusts & Estates Department
Published: Banker and Tradesman
November 18, 2018

Buried in the 2017 tax bill is a tax deferral and basis step-up provision aimed at luring investors to fund real estate development projects and new businesses in distressed, low-income communities. The favorable statute permits investors to (1) defer recognition of capital gains for up to 8 years by reinvesting those gains in a so-called Qualified Opportunity Fund (“QOF”); (2) exclude a portion of that deferred gain if the investment is held for a minimum of 5 years; and (3) exclude the gains resulting from the appreciation of a QOF if the investment is held for at least ten years. A QOF is a domestic corporation or partnership formed to invest in Qualified Opportunity Zone (“QOZ”) property.  8,761 communities dispersed throughout the U.S. were approved by the federal government as QOZs over the summer. The QOF may invest directly in QOZ business property or indirectly through investments in certain U.S. corporations or partnerships that invest in QOZ businesses.

This new tax break should have wide appeal, especially given the taxpayer-friendly, proposed regulations issued October 19. Investors should appreciate an additional planning strategy that affords them the ability to defer –and control the timing of – the recognition of capital gain. Wealthy families holding appreciated investment and family business assets will benefit from the opportunity to obtain a partial step up on the reinvestment of appreciated assets. Meanwhile, real estate investors should benefit from opportunities to pool capital, obtain favorable basis adjustments and ride on the coattails of others investing heavily in areas with vast upside potential.

In Massachusetts, Governor Charlie Baker designated 138 tracts as federal Opportunity Zones in 79 communities, including sites in Peabody, Worcester, Salem, New Bedford and Boston. In New Hampshire, the sites designated by Governor Chris Sununu include tracts in the Manchester Millyard, downtown Rochester, Keene, Newport and Conway.

Only Taxpayers With Capital Gains Are Eligible for the Tax Benefit:

Any taxable gains may be deferred by investing in a QOF. This includes the sale of stock, businesses, real estate and art, by individuals, trusts and estates, corporations, investment companies, REITs, and pass-through entities. Investments in a QOF must be made within 180 days of the sale or exchange that produced the capital gain. Hedge funds, private equity firms, large brokerages and real estate developers are rushing to establish QOFs for their clients to offer deferral of capital gains realized in year-end transactions and tap into the market for socially responsible investing.

The following example showcases the tax benefits. Mary recently sold a rental building and realized a $300,000 gain. On December 15, 2018, she invests her realized gains in a QOF that meets all of the statutory requirements. Mary reports her deferral election on her 2018 tax return. If Mary is still holding her interest in the QOF on December 31, 2026, she recognizes $255,000 in gain on that date (85% of deferred gain). If Mary continues to hold the property through December 15, 2028, her basis in her QOF interest equals the fair market value and any appreciation is not taxed. For example, if she sells her interest on December 30, 2028 for $500,000, she does not recognize any gain despite the appreciation in her interest. Therefore, Mary has eliminated $245,000 of gain from income tax as a result of investing in the QOF and holding her interest for 10 years.

Other Requirements:

The QOF must hold 90 percent of its assets in QOZ property. The proposed regulations create a “working capital” safe harbor, which permits a QOZ business to hold cash raised from investors for up to 31 months as “working capital” before it is required to have invested it in qualifying property.  These regulations also interpret a statutory requirement that “substantially all” of the tangible assets of a QOZ business be used in a QOZ to mean that the business must have at least 70% of its tangible property in the opportunity zone to qualify. In order to qualify as QOZ property, either the property’s original use must start with the acquisition by the QOF or the QOF must “substantially improve” the property. Substantial improvement is defined to exist only if over a 30-month period the QOF has additions to basis of the tangible property acquired by the QOF that exceed the amount of the adjusted basis of such tangible property (excluding basis in land) at the time of the acquisition of the property.

Remarkably Little Red-Tape:

To facilitate the certification process and minimize the burden placed on taxpayers, a corporation or partnership may self-certify as a QOF. There is no legal barrier to a pre-existing entity becoming a QOF, provided the entity meets all of the requirements. Expect that this tax break will continue to get serious attention in year-end and strategic planning meetings.