Sally recently sold some stock she held for decades, generating a $500,000 gain that will result in a hefty tax bill when she files her federal income tax return in early 2021. Sally is looking for ways to minimize her tax bill by reinvesting the proceeds. Her trusted advisor recommended investing in a Qualified Opportunity Fund.
The 2017 Tax Cuts and Jobs Act created a new tax incentive program known as Qualified Opportunity Zones. The IRS and Department of the Treasury finally released long-awaited final regulations on this program at the end of 2019, after releasing two sets of proposed regulations in late 2018 and early 2019. An Opportunity Zone (“OZ”) is an economically distressed, low-income community designated by the federal government. This incentive program is designed to spur economic development and job creation in these distressed communities across the United States by providing tax benefits to investors who invest capital into these communities.
There are generally two benefits under the OZ program, namely the “Deferral Benefit” and the “Exclusion Benefit.” Under the Deferral Benefit, investors can defer tax on capital gains that are reinvested in a Qualified Opportunity Fund (“QOF”) until the date the QOF investment is sold or December 31, 2026, whichever occurs first. Not only will the capital gain tax be deferred for a number of years, the gain will also be reduced by 10% if the QOF investment is held at least five years. The OZ program also provides for an additional 5% tax reduction, for a total of a 15% tax reduction, if the QOF investment was held for seven years, but because 2026 will trigger gain recognition, the additional reduction is obsolete at this point as there is not enough time for investments made in 2020 to be held for seven years by the recognition date. This has frustrated many investors as the final regulations that taxpayers could fully rely on did not become effective until March of this year, preventing any investor waiting on these regulations to become effective to reap the full seven-year benefit. However, maximum savings may be credited to the Exclusion Benefit, under which if the investor holds the investment in the QOF for at least ten years, then upon a sale of the investment, the investor can eliminate any gain on the QOF investment itself. The Exclusion Benefit is not confined by the 2026 deadline.
Investing in a QOF could be a great option for Sally, as it will allow her to defer and reduce the amount of money she owes in taxes. If Sally invests her $500,000 gain from her stock sale into a QOF, Sally can defer the tax due on the sale until 2027. Additionally, come 2027, not only will Sally have deferred her tax bill six years, the amount of tax will be reduced 10%, or roughly $10,000. Better yet, if Sally’s $500,000 investment is worth $750,000 in 2030, she will be able to sell the investment capital gain tax free with regard to the additional $250,000 gain. This results in a total tax savings of roughly $60,000, all while earning income off the QOF.
Qualified Opportunity Funds
A QOF is an investment vehicle that files either a partnership or corporate income tax return and is organized for the purpose of investing in Qualified Opportunity Zone property. For an entity to be recognized as a QOF, it must self-certify with the IRS. Anyone can form a QOF through the self-certification process. Additionally, to maintain its certification, at least 90% of the QOF’s assets must be considered Qualified Opportunity Zone property (“Qualified OZ Property”). There are three types of Qualified OZ Property: (1) partnership interests in a Qualified Opportunity Zone business; (2) stock in a Qualified Opportunity Zone business; and (3) Qualified Opportunity Zone business property, i.e., property used in the active conduct of a trade or business. This means a QOF must either own an equity interest in a qualifying business that operates within an OZ, or the QOF must be an operating business located within an OZ. Whether the QOF is a holding company or an operating company is a matter of investor preference, but the holding company structure will generally prove to be more advantageous.
Qualified Opportunity Zone Business
A QOF must either own or operate a Qualified Opportunity Zone business (“Qualified OZ Business”). A Qualified OZ Business is a business in which substantially all of its tangible property is considered Qualified Opportunity Zone business property (“Qualified OZ Business Property”). Qualified OZ Business Property is property that is: (1) acquired by the business from an unrelated party after December 31, 2017; (2) purchased new, or if used, it must be substantially improved by the business; and (3) mostly used within the boundaries of an OZ. For used property to be considered substantially improved such that it can be counted as Qualified OZ Business Property, the entity must essentially make enough improvements to the property that it doubles its basis in the property within 30 months. A few caveats are that: (1) unimproved land is not required to be substantially improved to qualify, but the unimproved land must be used in the active conduct of the business; (2) vacant property that has been vacant for five years does not need to be substantially improved in order to qualify; and (3) if a business purchases land with a building located on the land in an OZ, measuring the substantial improvement to the building does not require the business to separately substantially improve the land. For a business’s leased property to qualify as Qualified OZ Business Property, the property must be: (1) acquired under a lease entered into after December 31, 2017; (2) the terms of the lease must be market rate; and (3) substantially all of the business’s use of the leased property must be within an OZ. Under certain conditions, the lease may be between related parties.
There are three additional requirements for a business to be considered a Qualified OZ Business. These are: (1) at least 50% of the business’s gross income must be derived from the active conduct of its business within an OZ; (2) a substantial portion of its intangible property must be used in the active conduct of a trade or business; and (3) less than 5% its property may be attributable to nonqualified financial property (this includes debt, stock, options, future contracts, warrants, annuities, etc., but does not include reasonable amounts of working capital held as cash, cash equivalents, and debt instruments with a term of eighteen months or less).
In sum, in order to qualify for the Deferral Benefit and Exclusion Benefit under the OZ program, Sally must invest the amount of her stock sale gain proceeds into a QOF. The QOF must either own or operate a business in which most of the business’s property has been acquired after December 31, 2017, is either new or substantially improved, and is primarily used within an OZ. The business must also meet the three additional requirements noted above.
Taxpayer Eligibility Requirements
The OZ program allows an eligible taxpayer to elect to defer eligible gains from the sale or exchange of property with an unrelated person if the gain is invested in an eligible interest in a QOF during the 180-day period following the sale. An eligible taxpayer is any taxpayer that recognizes capital gains for federal income tax purposes. A partnership is an eligible taxpayer, but if the partnership does not elect to defer an eligible gain that is allocated to a partner’s distributive share, the partner may elect to defer the gain. The partner’s 180-day period begins on the last day of the partnership’s tax year (but the partner may elect to treat his or her 180-day period as the same as the partnership’s). An eligible gain is any gain that is treated as a capital gain for income tax purposes that would be recognized before January 1, 2027, and does not arise from a sale or exchange with a related person. An eligible interest in a QOF is an equity interest issued by a QOF, including preferred stock and partnership interests with special allocations. Debt instruments are not eligible interests, and an investor cannot contribute services in exchange for a QOF interest.
So, if Sally, an eligible taxpayer, contributes her $500,000 gain to a QOF within 180 days of the sale to an unrelated party, and she receives an equity interest in return, she will be eligible for the Deferral Benefit and Exclusion Benefit.
As noted above, investors can defer tax on eligible capital gains that are invested in a QOF until the date the investment is sold or December 31, 2026, whichever occurs first. Additionally, not only will the capital gain be deferred for a number of years, the gain will also be reduced by 10% if it has been held by the investor for at least five years. This is accomplished through a basis adjustment. The investor’s initial investment in the QOF will be zero. If the investment is held for five years, the investor’s basis will be increased by 10% of the gain deferred. The investor will then recognize the deferred gain upon the sale of its investment or December 31, 2026, whichever occurs first. Death will not trigger gain recognition, but could create a liquidity issue for the beneficiary that inherits the investment when recognition does occur, thus, estate planning is particularly important for investors dealing with QOFs. The gain, when recognized, will be equal to the lesser of: (1) the fair market value of the investment over the investor’s basis; or (2) the amount of the investor’s deferred gain over the investor’s basis.
To illustrate, assume on June 1, 2020 Sally realized her $500,000 capital gain from the stock sale. One month later, on July 1, 2020, Sally invested the $500,000 in a QOF. Her initial basis in the QOF will be zero. Five years later, on July 1, 2025, Sally will receive a 10% increase in her basis, so now her basis in the QOF is $50,000. December 31, 2026 rolls around and Sally still holds her investment in the QOF. This date will trigger gain recognition. At this time, the investment is now worth $600,000. Sally will recognize $450,000 of gain rather than $500,000 (her initial investment and amount deferred) because, using the rule above, the lessor of the fair market value of the investment over the investor’s basis ($600,000 – $50,000), and the amount of the investor’s deferred gain over the investor’s basis ($500,000 – $50,000) is the latter, or $450,000. By investing in the QOF, Sally saved approximately $10,000 in taxes by utilizing the Deferral Benefit.
An additional, and potentially even greater benefit is the Exclusion Benefit. With this incentive, an investor that sells or exchanges a qualifying investment in a QOF that he or she holds for at least ten years may elect to increase his or her basis in the QOF to its fair market value on the date the investment is sold or exchanged, thus, excluding any appreciation on the investment. Therefore, if in late 2030 Sally still owns the investment in the QOF but decides to sell because the investment has a fair market value of $750,000, she can elect to increase her basis to $750,000 on the date of the sale. She will then realize no gain from the sale of her investment in the QOF in 2030. One caveat with this benefit is that the investor must sell by December 31, 2047 in order to utilize this benefit. Commentators urge for an adjustment to this rule, as it encourages an exodus of capital out of otherwise distressed communities, but for now, investors should be cognizant of this requirement.
By investing her stock sale proceeds in a QOF for ten years, Sally saved over $60,000 in taxes ($10,000 from the Deferral Benefit and $50,000 from the Exclusion Benefit), and made an additional $250,000 off the QOF investment itself.
Investing in a QOF can be a great opportunity for investors looking to defer a sizable tax bill. There are a number of Qualified Opportunity Zones located in Nebraska and Iowa, including several in the Omaha Metro area. If you have any questions regarding Qualified Opportunity Zones, or are interested in learning more, please contact a member of the McGrath North Tax & Estate Planning Practice Group.