By now many taxpayers have heard about Opportunity Zones enacted under the Tax Cuts and Jobs Act 2017.
As a quick recap, the objective of Opportunity Zones is to spur economic growth in underserved areas by providing tax incentives to investors in return for investing in certain lower income areas. The tax benefits provided are a combination of deferred taxes, reduction in taxes, and elimination of taxes.
Deferred Tax Benefits
Short-term and long-term gains that are treated as capital gains for federal tax purposes can be deferred until 2027 – the deferred gain crystallizes on December 31, 2026, unless there is an earlier sale. This includes gains arising from actual and deemed sales. An added benefit here is the ability to collect income and further gains on the deferred gain. Given the current tax rates, etc. it is probable that investors could make more money on the deferred tax than the deferred taxes they would have to pay.
Reduction in Taxes
Where the investment in a Qualified Opportunity Zone Fund (“QOF”) is held for at least 5 years, there is a 10% reduction in tax. A further 5% reduction occurs where the investment is held for at least 7 years. The reduction is achieved by a step-up in the value of the deferred gain for a potential total 15% basis increase.
Many syndications are structured using pass-through entities. Given the 20% pass-through income deduction for pass-through entities, syndications investing in QOFs will also benefit from the pass-through deduction, which includes depreciation.
Elimination of Tax
There is a special gain exclusion for QOF investments held for at least 10 years. If a taxpayer elects, on the date the investment is sold or exchanged, the basis of the investment is stepped-up to its then full market value. Consequently, any gain attributable to the appreciation of the QOF investment held for at least 10 years is excluded from tax.
There has been much discussion in the real estate investing world regarding the need to have to invest in QOFs before December 31, 2019. It is correct to say that taxpayers seeking to maximize to benefit from the 15% maximum increase in basis, will need to invest in a QOF prior to December 31, 2019. However, investing after this date does not prevent the elimination of taxes from QOF gains, provided the investment is held for at least 10 years and the asset is sold prior to December 31, 2047 (note, there is a requirement to invest in QOFs by December 31, 2026).
How Opportunity Zones Work
The investment of both short term and long-term capital gains from the sale of stock, real estate, businesses and collectibles in QOFs receive tax benefits. Non-capital gains can also be invested in QOFs; however, these funds will not enjoy the tax breaks.
One of the redeeming features of the Opportunity Zone regime is the minimal administrative burden it creates for taxpayers and investors. No prior approval is required and, unlike 1031 exchanges, QOFs do not require the use of intermediaries. The only administrative requirement for QOFs is that investors file Form 8949 with their federal tax return electing inclusion in a QOF.
There are several requirements that must be met by both investors and the deal itself.
The key criteria investors must satisfy is they must make an investment in a QOF within 180 days of the gain being realized. Where the gain arises from the sale of real estate, only the net gains for the year arising from real estate qualify. For real estate investors this means the 180-day period to reinvest capital gains does not begin until the last day of the taxpayer’s tax year, not the date the property was sold.
For example, if Party A realized a gain of $250,000 from the sale of their interest in an apartment building on April 15, 2019, the 180-day period to reinvest the gain in a QOF would not begin until December 31, 2019.
Another key requirement is direct investments in property located in Qualified Opportunity Zones (“QOZ”) are not permitted. Instead, the investment must be made via a QOF. A QOF is an entity, such as a C-Corporation, partnership, or LLC that has self-certified as a QOF. Note, S-Corporations cannot be a QOF.
QOFs can invest in Qualified Opportunity Zone Business Property (“QOZBP”), which is any tangible property used in a trade or business acquired after 2017 that is substantially used in the QOZ or QOZ property that is substantially improved after the acquisition. Investments in “sin businesses”, such as massage parlors, racetracks, golf courses, country clubs, etc. are not allowed.
QOF Investing Requirements – Substantially Used
The QOF must meet the following asset test valuation requirements:
- 90% of the QOF’s investments must be in a Qualified Opportunity Zone Business (“QOZB”) or Qualified Opportunity Zone Property (“QOZP”); and
- 70% of the QOZB’s assets must be in QOZP.
In addition, QOZBs must derive 50% of income from within the QOZ. There is a 3-tier test for determining whether income is sourced from within the QOZ:
- 50% of hours worked are by employees located within the QOZ; or
- 50% of wages paid are to employees working within the QOZ; or
- Substantially all the QOZB’s tangible property is in the QOZ AND the operational and management functions of the QOZB necessary to generate 50% of gross income are in the QOZB.
Only one tier needs to be satisfied to meet the source of income requirements.
QOZs and Syndications
Thankfully the IRS has confirmed that the renting of real estate is regarded as the active conduct of a trade or business for QOZ purposes. Therefore, at least in theory, syndicators should be able to offer QOZ investment opportunities to their investors.
The rules require buildings located on land in a QOZ to be “substantially improved”. This requires the value of renovations to the building during a 30-month period from the date of acquisition to be at least equal to the taxpayer’s basis in the building. For example, if an apartment building was purchased for $1,000,000 had $200,000 allocated to the value of the land and $800,000 allocated to the value of the building, the taxpayer would need to invest at least $800,000 in renovating and improving the building.
The IRS’ current interpretation of “substantially improved” will prevent many value-add syndicators from providing their investors with opportunities to invest in QOFs. While it may be possible to overcome this hurdle by considering allocating more value to the land (which does not need to be substantially improved), doing so would likely increase the risk of a tax audit.
A further impediment for some syndicators will be the requirement for the building to be substantially improved within 30-months. Such a restrictive time limit could deter syndicators/developers who are looking to redevelop buildings that could take longer than 30 months from investing in QOZs. Considering the feedback received on these limitations, the Treasury has indicated it is reconsidering how to apply the substantial improvement required to help more projects get through the requirements.
No QOZ Tax Breaks for Deal Sponsors
While QOZs provide fantastic tax breaks for passive investors, due to the prohibition on transactions with related parties, deal sponsors cannot benefit from QOZ tax breaks by rolling gains from other deals into their own QOF (they can, of course, benefit by investing in someone else’s QOF).
Practical Considerations for Syndicators
These could be used where, for example, the deal includes a “sin business” such as a hotel with a golf course. If practical, it may be possible for the deal to be split into two parts – one for the hotel (QOF) and one for the golf course (non-QOF). This would require separate funds and raises for each part of the deal. This could be achieved by getting investors to divide their investments equally between the fund acquiring the golf course (no tax breaks) and the fund acquiring the hotel (attracts tax breaks). Before proceeding with side-by-side funds, it is highly recommended that you discuss the implications with your securities lawyer and tax advisor.
In many instances it may be advantageous for the QOF to invest in QOZP through a second tier QOZB subsidiary. This enables QOZ benefits to be obtained with only 63% of the capital raised invested in QOZBP. This is best illustrated with an example:
- $1,000,000 invested in a QOF
- The QOF invests $900,000 in QOZB and $100,000 in non-QOZ investments.
- The QOZB invests $630,000 (70% of QOZB assets) in QOZP and $270,000 in non-QOZ investments.
Gain/No Gain Investors
With many tax breaks the distribution of dividends is normally regarded as a taxable event. However, for QOZs, it is possible for LLCs, etc. to be formed with separate classes of stock. – for example, Class A1 investors can receive a 10% preferential return without benefiting in any gains and Class A2 investors can receive a 6% preferential return plus a share in any gains. Each class can receive different rates of return without creating a taxable event provided the distribution is made from income or proceeds from qualified non-recourse debt.
Many syndications are structured so that the members of the deal-sponsor team receive equity interests (Class B Interests) in return for services rendered. Receiving a QOF interest in return for services creates a “mixed fund”. The recipient of the sweat equity will not be eligible for QOZ benefits to the extent of the QOF value received for their services.
What About Securities Laws?
QOF investments are securities and must comply with securities law as well as the tax code. If you are interested in setting up a QOF for your next deal you will need to seek advice from both a qualified tax adviser as well as securities counsel. For additional information on the securities law implications of QOFs click here to schedule an appointment.