Deferring Gain by Investing in Qualified Opportunity Zone Funds

Article prepared by FGMK Tax Senior Associate Jeffrey Golds  

One of the many changes in the recent Tax Cuts and Jobs Act of 2017 (the “TCJA”) is the creation of a new economic tool: the Qualified Opportunity Zone Fund.  This tool allows taxpayers to defer tax on gains from the sale of property to an unrelated party by investing in a Qualified Opportunity Zone Fund (a “QOF”), and potentially avoid any taxation on appreciation on the QOF investment.   While much of this new law will require guidance from the U.S. Department of the Treasury, the following provides an overview of the newly enacted tax code provisions.

Qualified Opportunity Zones

The newly added Section 1400Z-1 lays out the procedure for designation of a Qualified Opportunity Zones.  A Qualified Opportunity Zone (“QOZ”) is any low-income census tract (a defined term under the law) designated by the chief executive officer of a state as a qualified opportunity zone and approved by the Secretary of the Treasury.  Additionally, a census tract which is contiguous to a designated QOZ may also be designated as such as long as the median family income of the tract is not 125% greater than the contiguous low-income community.   The first set of QOZs were designated on April 9, 2018, and as of June 2018, every state has designated QOZs. The locations of these zones are available through each state, as well as through the Community Development Financial Institutions Fund. There is significant, but not complete, overlap with census tracts which are eligible for New Markets Tax Credit projects.

Qualified Opportunity Zone Funds

Section 1400Z-2 lays out the rules for QOFs.  A QOF is an investment vehicle organized as a corporation or partnership which is formed for investing in qualified opportunity zone property (“QOZP”).  The QOF must hold at least 90% of its assets in qualified opportunity zone property (using a weighted average approach described in the law). The Internal Revenue Code (the “Code”), as written, gives the IRS the ability to draft regulations pertaining to the certification of a QOF; however, per a recently released IRS Q&A on QOFs, a QOF self-certifies as such. 

Qualified Opportunity Zone Property is either:

  • Qualified opportunity zone stock (presumably either a “C” or “S” domestic corporation);
  • Qualified opportunity zone partnership interest; or
  • Qualified opportunity zone property.

The ownership of Qualified opportunity zone stock or qualified opportunity zone partnership interest constitutes ownership in a qualified opportunity zone business.  A Qualified Opportunity Zone Business is a trade or business in which substantially all of the tangible property owned or leased is qualified opportunity zone business property.  In addition, a Qualified Opportunity Zone Business must derive at least 50% of its income from an active trade or business, must use a substantial portion of any intangible property owned in an active trade or business, and less  than 5% of the business’s unadjusted basis in property may be attributable to financial property (e.g. cash or marketable securities).

To qualify as Qualified Opportunity Zone Business Property (“QOZPB”), the fund must acquire such property by purchase after December 31, 2017 and before January 1, 2026.  The original use of such property must commence with the fund or the fund must substantially improve the property, which means it must double its adjusted basis over 30 months, and substantially all of the use of such property must occur in the qualified opportunity zone for substantially all of the qualified opportunity zone fund’s holding period.    A Qualified Opportunity Zone Business may not operate a so called “sin business”, which includes a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises

QOZP does not need to be located in the same state as the QOF. A QOF may invest in any property in the United States which is located in a QOZ.  Additionally, unlike with the New Markets Tax Credit program, a QOF may invest in property eligible for Low Income Housing Tax Credits.  However, a QOF may not invest in another QOF.  Moreover, should a QOF fail to have at least 90% of its assets invested in QOZP, the QOF will be required to pay a monthly penalty (subject to possible reasonable cause exceptions) in the amount of the difference between 90% of the QOF’s assets and the percent of such assets invested in Qualified Business Property, multiplied by the Federal Short-Term Interest Rate plus 3%. In a situation where tangible property that originally qualified as QOZBP ceases to qualify, it will continue to be treated as qualifying for up to five years from the date of disqualification.

Investing in a QOF

As described under Section 1400Z-2, a taxpayer who realizes a gain on the sale of property may invest such gain in a QOF and defer the recognition of such gain until the earlier of sale or redemption of the QOF interest or December 31, 2026.  Such gain must be invested in a QOF within 180 days of the property sale that created the gain.  Mechanically, the gain is deferred by making an election on the taxpayer’s income tax return. However, the taxpayer takes a basis of $0 in the QOF interest.  As a result, the taxpayer may recognize the lesser of the deferred gain or the fair market value (“FMV”) of the QOF interest at the time of its sale.  This means that, if the investment loses value, the excess of the originally deferred gain will be eliminated entirely. 

Unlike IRC 1031 tax deferred exchanges, only the gain, rather than the entire sales price need be reinvested. Furthermore, it would appear that there is no need to escrow or otherwise set aside the gain proceeds.

As additional incentives to hold QOF investments long term, the Code provides that, after five years, the basis of the QOF interest will increase from $0 to 10% of the deferred gain.  Then, after seven years, the basis will increase by an additional 5% of the deferred gain.  If the QOF is still held by the taxpayer on December 31, 2026, the taxpayer will be required to recognize the deferred gain up to the FMV of the interest as of that date (less the stepped up amounts, if applicable), and will take a FMV basis in the QOF interest.  However, at the taxpayer’s election, property held for at least 10 years will have a basis of whatever the FMV of the QOF interest is the day of the sale.  Should the taxpayer hold the QOF interest for at least 10 years and make the election, any appreciation of the QOF interest above the gain recognized at the end of 2026 would be tax free. Note that if the election was made (gain reinvested) and the QOZBP is sold in less than the applicable period, the gain can’t be reinvested in other QOZP. Furthermore, it appears that a QOF could invest in property which would produce tax credits. For instance, a building could install solar panels on the roof and then allocate the Section 48 energy credits to the holders of the QOF interest.  In doing so, the QOF could produce current year benefits for the interest holders in addition for allowing for the long term gain deferral.  Note that if a taxpayer invests funds which are not related to a deferred gain into a QOF, the taxpayer would receive a normal partnership interest/member interest in the fund: the deferral of gain and potential elimination of appreciation would not be available with respect to such interest.  As such, if an investor invests in a fund, only a portion of which relates to a deferred gain, the investor will receive two distinct interests in the QOF, and only the interest related to the deferred gain will receive the special treatment described herein.

Example: Investment in a QOF in 2018

An example of the how a taxpayer could take advantage of these rules is as follows:  A sells a building he owns on July 1, 2018 for $100,000.  The building had a basis in A’s hands of $50,000 at the time of the sale.  A immediately invests $50,000 in a QOF.  In 2018, A would not recognize the $50,000 of gain on the building (the “Deferred Gain”), and A would have an interest in the QOF with a FMV of $50,000 and with a basis of $0.

Example 1: Sale in 2022

In the first scenario, A sells his QOF interest on July 1, 2022 for $50,000 to a third party buyer in an arms-length transaction.  A would have gain on the sale of the QOF interest of $50,000, which is equal to the Deferred Gain.   Alternatively, if A sells the QOF interest for only $40,000, then A will recognize only $40,000 of gain, as A is required to recognize the lesser of the FMV at the time of sale, or the Deferred Gain.  Finally, if A sells the QOF interest for $60,000.  A would recognize $60,000 of gain in a two-step process:  1) A recognizes $50,000 of deferred gain in 2022, and takes a $50,000 basis in the QOF interest, and 2) A recognizes $10,000 of gain on the sale of QOF interest for the excess of the $60,000 sales price over his $50,000 basis.

Example 2: Sale in 2024

In the second scenario, A holds his QOF interest for six years, and sells it on July 1, 2024 to a third-party buyer in an arms-length transaction.  A would now have a basis in the QOF interest of $5,000 due to the 10% step up after five years.  Therefore, A would recognize $45,000 of gain in 2024 (the Deferred Gain less the stepped up basis).  Alternatively, if A sells the QOF interest for $40,000, A would have $35,000 in gain, which is the FMV at the time of the sale, less A’s $5,000 basis.

Example 3: Asset held through December 31, 2026

In the third scenario, A is still holding his QOF interest on December 31, 2026.  A now has a basis in the QOF interest of $7,500 due to the 10% step up after five years and additional 5% step up after seven years. If the QOF interest has a FMV of $50,000, A would recognize $42,500 of gain at the end of 2026.  Alternatively, if the QOF interest only has a FMV of $40,000, A would recognize $32,500 of gain at the end of 2026, which is his stepped up basis less the FMV.

Example 4: Sale in 2029

Finally, A sells the QOF interest on July 1, 2029 for $100,000.  As A has held the QOF interest for more than 10 years, he makes the election under 1400Z-2(c), and takes a basis in the QOF interest of $100,000 at the time of the sale.  A therefore recognizes no gain on the appreciation of the QOF interest.  This is true regardless of what A’s basis was prior to the sale. 

Below is a chart summarizing the results described in the examples above:

 

Example

1

Example

2

Example

3

Example

4

Year

2022

2024

2026

2029

Basis in QOF

$0

$5,000

$7,500

$40,000*

Gain on $40,000 sale

$40,000

$35,000

$32,500

$0

Gain on $50,000 sale

$50,000

$45,000

$42,500

$0

Gain on $60,000 sale

$60,000

$55,000

$52,500

$0

*For purposes of this table, assume the interest had a FMV of $40,000 at the end of 2026 and recognized gain of $32,500, resulting in a $40,000 basis prior to the sale in 2029.

 

Planning Ideas and Uncertainty

As the market develops around QOFs, various planning ideas have emerged as well.  An owner of real estate looking to develop a new property could sell its existing property and invest in a new property through a QOF.  The owner would still manage the new property the same way it always did, but would now have the potential to avoid taxation on any appreciation of the new property.  Similarly, a business looking to open a new facility might open the facility in a Qualified Opportunity Zone and use a QOF to avoid tax on appreciation.  However, as the IRS and Treasury have yet to release regulations related to QOFs, there are still many questions as to how, exactly, these funds will work.  For instance, there is no rule as to how a QOF taking on loans might impact the basis of the holders of QOF interests.  There are no rules as to whether or not QOF’s can disperse operating profits to interest holders, or whether such profits need to be reinvested.  There are no rules as to how exactly the 90% Qualified Business property test would be conducted: would the changes to the basis of the underlying assets, either through depreciation or market fluctuations impact the numbers used for testing? 

These questions, as well as numerous others, suggest that until further guidance is issued, operating an investment in QOZP should be administered in a conservative, cautious manner.  Under the right circumstances there is tremendous opportunity to minimize income tax through the use of the QOZ provisions. Taxpayers considering QOFs should contact their FGMK, LLC consultant to further explore creative ways to benefit from this new law.

 

About FGMK

FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.

 

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