The Tax Cuts and Jobs Act of 2017 added Internal Revenue Code Section 1400Z, which created a new program to encourage investment and job creation in economically distressed communities designated as qualified opportunity zones (QOZs). At its core, this program provides preferential tax treatment and benefits for investors who reinvest capital gains into QOZs.
Although much has already been written about the tax benefits of QOZs, there’s been less discussion of whether these investments are right for individual investors. As we’ll identify, there are various issues a potential individual investor should consider before proceeding with an investment. Evaluating whether a QOZ investment is an appropriate investment is no different from evaluating any other investment strategy with returns that may be enhanced by certain tax benefits. For individual investors, understanding how a QOZ investment will be treated for tax purposes, not only as to their personal ownership but also as an asset within their gift and estate plan, is an important part of the evaluation process when considering QOZ investments.
Overview of the QOZ Program
A QOZ is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. A community qualifies as a QOZ if it’s nominated by the state where it’s located, and that nomination has been certified by the Internal Revenue Service.1
In essence, there are two ways in which an investment can be made in a QOZ. For institutional scale investors, a direct investment can be made in a property or a business located in a QOZ (for example, a real estate development firm may buy a building located in a QOZ) or a company may choose to locate an office in a QOZ (for example, through a long-term lease rather than a purchase of property). For non-institutional scale investors, a qualified opportunity fund (QOF) is an investment vehicle that allows individual investors to partake in the tax benefits of the QOZ program.2 A QOF is set up as either a domestic partnership or corporation that invests in eligible property that’s located within a QOZ;3 investors can invest gains from a prior transaction in the QOF and receive the preferential tax benefits of the QOZ program. We’ll focus on evaluating the merits of an individual investor investing in a QOF, and the terms “QOZ” and “QOF” may be used interchangeably.
Three Potential Benefits
The QOZ/QOF program provides three potential federal income tax benefits:
1. The ability to defer the capital gains on the sale or disposition of property to an unrelated person, provided the gains are reinvested into a QOF within 180 days of the sale or disposition. The deferral is available until the earlier of: (1) the date on which the subsequently acquired interest in the QOF is sold or exchanged, or (2) Dec. 31, 2026;
2. The elimination of up to 15% of the gains reinvested in the QOF, provided certain holding periods are met; and
3. The elimination of any gains realized on the QOF interest from the time of initial investment to the sale or exchange of the QOF interest for federal income tax purposes through a step-up in basis of the fund interest to its fair market value (FMV) on that date, if the QOF interest is held for a minimum of 10 years.
Breaking Down the Tax Benefits
To qualify for the federal income tax benefits of the QOZ program, an investor must reinvest gains4 from the sale or disposition of property into a QOF within 180 days of the property’s sale or disposition to an unrelated party (subject to potential relief in the case of certain pass-through entities).5 The gains can be long term or short term, actual or deemed. The investor must also make an election to defer the gains, in whole or in part, by filing Form 8949 (Sale and Other Dispositions of Capital Assets) with the federal income tax return for the tax year when the tax on those gains would otherwise be due if they weren’t deferred. By investing the gains in the QOF and making the appropriate election, the tax due on those gains is deferred until the earlier of the investor’s sale of the subsequently acquired QOF interest or Dec. 31, 2026.6
While the deferral of tax due in and of itself is a tremendous benefit, the incentives of the QOZ program go well beyond deferral. While an investor’s basis in a QOF interest is initially zero, it’s increased by an amount equal to 10% of the deferred gains if an investor holds the QOF interest for at least five years; if the QOF interest is held for at least seven years, that basis adjustment is increased an additional 5% to an amount equal to 15% of the deferred gains in total. Given that the end date for tax deferral of gains is Dec. 31, 2026, an investor must invest in a fund by the end of 2019 to obtain a step-up in basis of 15% or by the end of 2021 for a step-up in basis of 10%.
Perhaps most significantly from a tax savings point of view, if the QOF interest is held for a minimum of 10 years, and the taxpayer makes the appropriate optional election, any gains on the QOF interest itself, from the time of initial investment to sale or exchange of the QOF interest, will be eliminated for federal income tax purposes through a step-up in basis of the QOF interest to its FMV on the date of sale or disposition.
This third benefit is important in mitigating concerns around one important unknown. One question that remains unanswered, despite two rounds of guidance on QOZs and QOFs from Treasury,7 is which year’s tax rates will apply when the inclusion of the deferred gains occurs (that is, the tax rate in the year that the gains were initially deferred or the tax rate in the year that the gains are included and taxable to the investor). In the absence of the third benefit—eliminating gains on the QOF interest in certain circumstances—the risk that tax rates will increase during the period that the gains are deferred may reduce the benefit of the 10% to 15% reduction in gains as the QOF is held for the 5-year to 7-year holding period.
QOZs as Investment Strategies
When viewed through a tax planning lens, the benefits of investing in a QOF almost seem too good to be true. However, it’s important to recognize that, to reap these tax benefits, an individual investor must have several specific characteristics. As a threshold matter, the investor must have realized gains not yet recognized for federal income tax purposes. Further, there must be a willingness and ability to reinvest and lock up such gains for an additional period of time, that is, the investor must have capital that isn’t necessary to meet lifestyle needs or other immediate financial goals.
Perhaps most importantly, an investor must have an awareness of and willingness to accept the risks associated with the QOF as an asset class. QOFs are an entirely new category of asset class in which no manager has a track record, and showing a “backcast” of past real estate development projects that would have qualified isn’t analogous to an actual history of performance. To completely understand the QOF as an investment, one must drill down and consider the projects in which the QOF is invested. Does the person running the development project have experience running this type of investment? Projects undertaken in a QOZ are subject to local laws and restrictions—is there buy-in at the state and local level with respect to the proposed projects? Is the cost and complexity of small local investments manageable by the QOF? The recent failed endeavor by an Internet concern to build a corporate headquarters in New York City’s Long Island City neighborhood (in a QOZ) is a prime example of how the projects underlying these investments may be speculative and by no means are done deals.
There are many other questions to consider:
• Are the QOF’s holdings diversified, such as by location?
• Are there restrictions on liquidity for the investor as well as for the QOF itself given the nature of its holdings? Keep in mind that the Dec. 31, 2026 outside date for the recognition on the deferred capital gains occurs regardless of whether the QOF has arranged for any kind of payment or distribution, potentially creating a liquidity crunch for QOF investors who intend to remain invested past Dec. 31, 2026.
• Not all states will choose to conform to the QOZ program and offer corresponding tax benefits at the state and local level, that is, decoupling from the federal law in this regard. Does the potential investor reside in a decoupled state such that only federal income tax benefits are available?
• How does the investment of a QOF fit into an investor’s overall portfolio and affect his asset allocation goals?
Other Considerations
For clients focused on gift and estate-planning objectives and/or older clients, a QOF investment requires special considerations.
After the first round of proposed regulations were issued in October of 2018,8 comments were submitted to the Treasury Department highlighting that if an individual dies holding a QOF interest, IRC Section 691 (the income in respect of a decedent rule) could trigger inclusion of deferred income in the gross income of the decedent’s beneficiaries. In the case of a QOF interest, a tax could be triggered without any corresponding liquidity. The most recent round of proposed regulations issued in April 2019 (the April proposed regs)9 addressed this concern by providing that transfers of QOF interests made pursuant to the death of the owner of the interest aren’t “inclusion events” (that is, events that trigger inclusion of deferred gains) for purposes of IRC Section 1400Z-2(b). However, this clarification doesn’t solve the inherent liquidity issue—what if there’s a liquidity need in the decedent’s estate (that is, estate taxes due), and the QOF interest can’t be liquidated? Of course, strategies exist to mitigate this liquidity risk, but potential investors must be aware that such a risk exists to appropriately plan.
The April proposed regs also clarified that a transfer of a QOF interest to a wholly owned grantor trust isn’t an inclusion event, meaning that the QOF interest held in the trust will receive the same income tax treatment and benefits as if held in the hands of the grantor.10 This rule could prevent the beneficiaries of the trust from being burdened with sizable gains. However, care should be taken when transferring QOF interests into a grantor trust to ensure that grantor trust status isn’t “toggled off,” triggering an inadvertent inclusion event.
Finally, the April proposed regs also clarified that any other type of gift transfer is an inclusion event, including a charitable contribution of a QOF interest, because the owner’s qualifying investment is terminated on the transfer to charity.11 Potential investors must consider this limitation in evaluating whether a QOF investment comports with their gift and estate-planning goals.
Not Risk Free
Investment in a QOF (and the tax benefits) doesn’t come risk free. Perhaps a more appropriate way to think of a reinvestment of gains into a QOF isn’t as a tax deferral opportunity but as an investment with both investment risks as well as special tax benefits that may enhance the return.
With this in mind, one should discuss not only the tax benefits with a client but also what the investor hopes to achieve with an investment in the QOF, how it fits in with the overall portfolio and the risks to consider. It’s important to keep in mind the risk tolerance of the investor with regard to the gains to be reinvested into a QOF—how much of the gains to be reinvested would the investor be comfortable losing?
Endnotes
1. Specific areas qualify as opportunity zones (QOZs) if these areas were nominated by the state or U.S. territory where they’re located and certified by the U.S. Treasury Secretary. The final list of QOZs was approved in 2018 and can be found in IRS Bulletin No. 2018-48. The list includes more than 8,700 zones located in all 50 states, as well as Washington, D.C., American Samoa, Guam, Northern Mariana Islands, Puerto Rico and U.S. Virgin Islands. A complete list of all QOZs, updated as of Dec. 14, 2018, is available at the U.S. Department of the Treasury’s Community Development Financial Institutions Fund website: www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
2. Two sets of proposed regulations pertaining to the QOZ program have thus far been released. See REG-115420-18 (Oct. 19, 2018); REG 1201866-18 (April 17, 2019). The proposed regulations released in October focused more on providing guidance to encourage initial individual investment in QOFs; the proposed April regulations provided more guidance for businesses operating and investing in QOZs.
3. A QOF must be organized for the purposes of, and have at least 90% of its assets invested in, QOZ property. QOZ property includes QOZ stock, QOZ partnership interests and QOZ business property. See Internal Revenue Code Section 1400Z-2(d) and REG-115420-18. To become a QOF, the entity self-certifies itself using Internal Revenue Service Form 8996, Qualified Opportunity Fund; a draft of Form 8996 is available at www.irs.gov/pub/irs-dft/f8996--dft.pdf, and a draft of the corresponding instructions is available at www.irs.gov/pub/irs-dft/i8996--dft.pdf. A detailed discussion of how property qualifies as QOZ property and how a fund satisfies the requirements to become a QOF is beyond the scope of this article.
4. If only a portion of the gain is reinvested into the QOF, then only that part of the gain that was invested in the QOF is eligible for deferral. If both capital gains and principal (or cash from other sources) are invested into a QOF, the investment will be treated as two separate investments into the fund. Gains incurred within the fund on the portion of the initial investment sourced from non-capital gains aren’t eligible for either reduction of gains (through a step-up in basis) or elimination of gains at time of sale of the fund.
5. For partners, members of limited liability companies and S corporation shareholders, the 180-day period begins to run at the end of the entity’s tax year including the date of sale. REG-115420-18 (Oct. 19, 2018). For IRC Section 1231 gains, the 180-day period begins to run at the end of the entity’s tax year including the date of sale. REG 1201866-18 (April 17, 2019).
6. IRC Section 1400Z-2(a)(2).
7. REG-115420-18 (Oct. 19, 2018); REG 1201866-18 (April 17, 2019).
8. REG-115420-18 (Oct. 19, 2018).
9. REG 1201866-18 (April 17, 2019).
10. Ibid.
11. Ibid.