The program, enacted as part of the Tax Cuts and Jobs Act, was created to help spur economic activity by investment in low-income neighborhoods in exchange for deferred capital gains. The incentive creates qualified opportunity funds (QOFs), which are partnerships or corporations formed specifically to invest in QOZs. Due to other tax reform matters commanding the headlines, this part of the bill largely flew under the radar. The following answers several common questions about the new tax incentive.
Anyone with a capital gain is eligible to participate. The capital gain can come from any type of property including public stocks, mutual funds, private businesses, or real estate.
QOFs that accept third-party investors may be subject to accredited investor rules, meaning there are minimum requirements for net worth ($1 million) or income ($300K married, $200K individual). However, there are mass marketed products that do not have such requirements.
There are eligible opportunity zones in all 50 states. In early 2018, states nominated up to 25% of the low-income census tracts within the state. The IRS released a bulletin certifying the full list of QOZs, which can be found on this interactive map.
A QOF is an entity that either invests in tangible property (typically real estate or a development project) within a QOZ directly or invests indirectly through an equity interest in a subsidiary. For a QOF to qualify under IRS rules, effectively all of the property has to be within a designated opportunity zone. Alternatively, a QOF can own an interest in a corporation or partnership, and the investment will qualify if the underlying entity derives 50% or more of its gross income from an active business in a QOZ. The business also cannot be a “sin business,” such as a liquor store, casino, etc.
The QOZ property must be acquired after December 31, 2017. If an existing property, the fund must substantially improve the property by at least the purchase price (the initial basis) within 30 months following the acquisition. The “property” does not have to be real estate necessarily and could be a business interest.
How are capital gains and deferrals treated?
An investor can reinvest the capital gains on a property sale to defer and/or reduce those capital gains taxes. The first step is to identity a QOZ fund to invest in within 180 days of the sale of the property. The initial tax basis in the qualifying investment is zero. After the investment is held for five years, the tax basis in the original investment is increased by 10% of the deferred gain. After the investment is held for seven years, the tax basis increases an additional 5% to a total of 15%. Investors must recognize gain by the earlier of when the QOF is sold or December 31, 2026, on the original 85% of capital gains. After ten years, investors permanently avoid any capital gains tax on the post-acquisition gains as it steps up to fair market value. There is no limit on the amount of gain that can be used.
There are literally trillions of dollars of capital gains eligible to participate. Deferring capital gains with potentially minimal taxes owed is a game changer. This is truly something new that creates wins for communities, developers, and investors. Nonetheless, investors must be vigilant considering the risks of any QOF and how it fits into the construction of an investment portfolio. Questions?
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Guest Article by Skoda Minotti
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