Buried in the 2017 tax bill is a tax deferral and basis boosting provision aimed at luring investors to fund real estate development projects and new businesses in distressed, low-income communities. The statute permits investors to
- defer recognition of capital gains for up to 8 years by reinvesting those gains in a so-called Qualified Opportunity Fund (“QOF”)
- exclude a portion of that deferred gain if the investment is held for a minimum of 5 years
- 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. There were 8,761 communities throughout the U.S. approved by the U.S. Treasury as QOZs over the summer. The QOF may invest directly in QOZ business property or indirectly through investments in certain domestic corporations or partnerships that invest in QOZ businesses.
This new opportunity for income tax deferral and basis increase should have wide appeal, especially given the generous interpretation of the particulars in the proposed regulations issued October 19. It allow investors to defer –and control the timing of – the recognition of capital gains. Wealthy families holding appreciated investments and family business assets will benefit from the opportunity to obtain a partial step up (an upward adjustment in the tax basis of an asset) on the reinvestment of appreciated assets. The opportunity to obtain a tax benefit while helping redevelop distressed communities may appeal to investors interested in socially responsible investing and repurposing decayed infrastructure. 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 potential.
The 27 sites in New Hampshire designated as federal Opportunity Zones by Governor Chris Sununu include tracts in the Manchester Millyard, and Rochester, Keene, Newport and Conway. Massachusetts Governor Charlie Baker, meanwhile, designated 138 tracts in 79 Massachusetts communities, including Peabody, Worcester, and Boston.
Eligibility for the Tax Benefit:
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, investment companies, REITs, and pass-through entities. The rules with respect to partnerships are particularly favorable. Even if a partnership doesn’t elect deferral, an individual partner may make an election under the regulations. This rule also applies to “pass-through entities other than partnerships,” including S Corporations and their shareholders as well as trusts and their beneficiaries.
QOF investing represents a significant diversification opportunity with beneficial tax consequences. 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 benefits. Mary recently sold a rental building for $400,000 that she had purchased five years ago for $100,000, realizing a $300,000 gain. On Dec. 15, she invests the $300,000 of realized gains in a QOF. When Mary files her tax return she reports her capital gain deferral election.
If Mary is still holding her interest in the QOF on December 31, 2026, she recognizes $255,000 in gain on that date (85 percent 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.
Investments in a QOF must be made within 180 days of the sale or exchange that produced the capital gain. Only property purchased by a QOF after December 31, 2017 is eligible.
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. The QOZ 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 has to be new to the opportunity zone (such as new construction) or the QOF must “substantially improve” the QOZ property by at least doubling the tax basis of the property over a 30-month period. For this test, the tax basis in the land is excluded.
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 an existing business becoming a QOF, provided the business meets all of the requirements.
Expect that this tax break will continue to get serious attention in year-end and strategic planning meetings.