The recently adopted Qualified Opportunity Zone Program (QOZ), introduced in 2017’s Tax Cuts and Jobs Act, is emerging as a potentially significant federal economic development tool that could improve the outcomes of distressed communities throughout the United States. Through the QOZ program, investors can inject capital into government-designated, economically-depressed communities and promote long-term economic growth through a variety of investment vehicles.
The program’s benefits include gain deferral and gain elimination for taxpayers who roll over capital gain into a Qualified Opportunity Fund (“QOF”). Specifically, if an investor (i) recognizes capital gain from the sale of an asset to an unrelated person, (ii) invests an amount equal to all or part of the capital gain in a QOF within 180 days of the date the gain is recognized, and (iii) makes an election (on IRS Form 8949) to treat the investment as a QOZ investment, the investor may be eligible for QOZ benefits. A fund which is merely a partnership or corporation for federal income tax purposes (and not a disregarded entity), may qualify as a QOF if 90% or more of its assets are comprised of (i) Qualified Opportunities Zone Business Property (QOZBP) and/or (ii) interests in a partnership or corporation (and not a disregarded entity) that qualifies as a Qualified Opportunities Zone Business (QOZB).
QOZBP’s must be (i) acquired after December 31, 2017 and (ii) “substantially improved” within the 30-month period after acquisition, rather than simply held. The definition of substantial improvement requires that improvements be worth at least as much as the tax basis of the QOZBP at the time of acquisition.
Taxpayers can also be eligible for other tax benefits if they hold their investment in the fund for a specified time. If a taxpayer holds a QOF investment for 5 or more years, 10% of the deferred gain is forgiven permanently (i.e., the tax basis is increased by 10% of the amount of the deferred gain). If a taxpayer holds a QOF investment for 7 or more years, 15% of the deferred gain may be forgiven permanently (i.e., 10% plus 5%, not an additional 15%; the tax basis is increased by 15% of the amount of the deferred gain). If investors hold for 10 years, no capital gains tax is paid on the appreciation in the investment (i.e., the basis is deemed to equal the fair market value on the sale date). Deferred gains are taxable on the earlier of (i) sale or (ii) December 31, 2026. However, on December 31, 2026 investors may have a liquidity issue (i.e., taxable income with no cash flow), unless the QOF makes a distribution to its investors to cover the tax liability or another funding mechanism is employed.
Unlike a 1031 tax deferred exchange (“1031”), there is no requirement that a qualified intermediary hold the cash from sale of the property before it is used to acquire replacement property. In other words, the taxpayer can receive the cash proceeds from the sale, freely use the cash for any purpose, and then later invest cash equal to the capital gain in a QOF to get a tax deferral. The key distinction from a 1031 is that any capital gain can be rolled into QOF.
The requirements to invest in QOZBP or funds are complex and nuanced, and it is important to assemble a strong team to properly document the investment. While there may be substantial tax advantages, such advantages would not make up for (i) a bad real estate investment decision or (ii) not having the right team to execute on the business plan. A team should include members with investment, tax, legal, finance experience and deep knowledge of the QOF requirements. If you have any questions about investing in or forming and operating a QOF or QOZB, please contact an attorney or accountant before proceeding too far down that road.