All About Qualified Opportunity Funds – New Tax Tool Available To Defer and Possibly Eliminate Gains
Effective January 1, 2018 the Tax Cuts and Jobs Act established Federal Qualified Opportunity Zones (QOZs) with the goal of allowing large amounts of capital to flow into economically distressed area across the country. To promote capital investment in these Qualified Opportunity Zones, legislators included three favorable tax provisions that benefit qualifying taxpayers. First, the ability to defer paying tax on capital gains until December 31, 2026. Second, basis increases which reduce deferred gains and lower the eventual capital gain tax to be paid by December 31, 2026 on deferred gains. Third, zero tax on new capital gains derived from capital appreciation in Qualified Opportunity Fund (QOF) investments held for at least 10 years.
Wait, what are Qualified Opportunity Zones?
The new tax law authorized the creation of Qualified Opportunity Zones (QOZ) which are defined as census tracts in low income communities and specifically designated as QOZs. The QOZs, now finalized by Treasury, were identified and nominated by the governor of each state or territory in which the zone is located. Governors were directed to select zones that were the focus of economic development and areas which had recently experienced significant layoffs due to business closures and relocations.
The Treasury Department has already reviewed and approved the list of opportunity zones. To view Federal Qualified Opportunity Zones visit this link, and follow the direction for using the map.
How Qualified Opportunity Funds (QOFs) Correspond to Qualified Opportunity Zones (QOZs)
A Qualified Opportunity Fund (QOF) is an investment vehicle created for investing in eligible property located in a Qualified Opportunity Zone. Investments in these funds provide for the three tax benefits listed in the first paragraph of this article. To qualify as a Qualified Opportunity Fund, 90% of the assets held by the Fund must be Qualified Opportunity Zone Property (QOZ Property). QOZ Property is property that was acquired after December 31, 2017 located in a Qualified Opportunity Zone, and is described in more detail below.
One of the largest opportunities that our firm sees with these types of investments pertain to investments in existing real estate needing significant improvements, new real estate development projects located in Qualified Opportunity Zones, and investments in businesses requiring significant amounts of tangible assets to operate. However, the details of all the types of property that qualify are summarized here as well. QOZ Property is defined as Qualified Opportunity Zone Stock (QOZ Stock), Qualified Opportunity Zone Partnership Interest (QOZ Partnership Interest), or Qualified Opportunity Zone Business Property (QOZ Business Property).
- Qualified Opportunity Zone Stock: The QOF can buy stock of almost any business except for “sin” business such as tanning salons, liquor stores, adult entertainment, casinos, racetracks, etc. The stock must be acquired after 12.31.17 at its original issue in exchange for cash; at the time the corporation was formed the business was a QOZ Business (defined below) or for a new corporation, it was formed to be a QOZ Business; and during substantially all of the QOF’s holding period of the stock, the corporation was a QOZ Business.
- Qualified Opportunity Zone Partnership Interest: A QOF can invest in a partnership capital or profits interest which meets the following requirements: 1) the interest is acquired by the Qualified Opportunity Fund after December 31, 2017, from the partnership, solely in exchange for cash; at the time the interest was acquired, the partnership, was a QOZ Business (defined below) or for a new partnership, it was formed for purposes of being a QOZ Business; and during substantially all the QOFs holding period of the interest, the partnership was a QOZ Business.
- Qualified Opportunity Zone Business Property: this property is tangible property used in a trade or business of the Qualified Opportunity Fund (QOF) and meets all of the following requirements: the property was acquired by the QOF by purchase from an unrelated party in accordance with Section 179(d)(2); the original use of the property located in the Qualified Opportunity Zone begins with the QOF or the QOF substantially improves the property; and the business is not a private or commercial 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 (“sin” businesses). Substantial improvement of a property is defined as occurring if the original basis of the property at its date of acquisition is at least doubled over a 30 month period beginning on the date of acquisition. For example, if a QOF purchased existing real estate located in a Qualified Opportunity Zone, it must substantially improve (defined as doubling the cost basis of the property over 30 months) for the property be qualified.
As mentioned in “1” and “2” above, QOZ Stock and QOZ Partnership Interests must relate to Qualified Opportunity Fund Businesses (QOZ Business). A QOZ Business is a trade or business that meets the following requirements
- At least 50% of the total gross income of the QOZ Business is derived from an active trade or business;
- A substantial portion of any intangible property is used in an active trade or business;
- Less than 5% of the average of the aggregate unadjusted bases of the property of the entity is attributable to nonqualified financial property (debt, stock, partnership interests, options, forward or futures contracts, notional principal contracts, annuities, etc.), and the business is not a “sin” business (mentioned above).
Tax Reporting as a Qualified Opportunity Fund
A taxpayer can designate its entity as a Qualified Opportunity Fund (QOF) via a one page self-certification Form still in process of being drafted by the IRS and attaching this to their tax return. A Qualified Opportunity Fund will file the typical Corporate or Partnership business tax returns, but must meet certain testing hurdles several times throughout the year to insure compliance with the 90% of assets held in Qualified Opportunity Zone Property is met. Failure to maintain a 90% investment in Qualified Opportunity Zone assets will result in a tax penalty to the fund equal to the shortfall under 90% times the existing IRS Underpayment Rate.
Now, why should you care about all of this – what’s in it for taxpayers?
There are three tax benefits available depending on how long an investor holds the QOF interest. In considering the below, remember that investors do not need to live or work in the Qualified Opportunity Zone to gain tax benefits from the investment.
- Tax Deferral until December 31, 2026
An investor who has or is about to realize capital gains from an investment (stocks, real estate, sale of a business, etc.) can elect to invest the amount of that gain into a QOF and the capital gain will be deferred until the earlier of two dates: when the interest in the QOF is sold or Dec. 31, 2026. The taxpayer has 180 days from the date of sale to roll the gain into a QOF and a “qualified intermediary” is not required to hold the capital during that time. In addition, unlike “like-kind exchange”, only gain need be invested in a QOF – not the original principal.
- Tax Reduction on Deferred Amounts (basis increases)
A taxpayer’s initial investment in a QOF will have zero basis since gain is being deferred into the fund. If a taxpayer holds the QOF investment at least 5 years before December 31, 2026 the investor receives a 10% step up in basis on the amount deferred. If held for 7 years before December 31, 2026 an additional 5% step up in basis is received. For example, if you had 2018 gains of $100,000 that you invested in a QOF and held the investment for 5 years before disposition the gain you would pay tax on when sold would only be $90,000 as you would receive a $10,000 basis step up (10%) for holding the asset at least 5 years. If you held it another two years, for a total of 7 years before disposition, you would only pay tax on $85,000 of the original deferred gain. Please note, to receive the full 15% step up for holding property for 7 years the QOF investment must be made by December 31, 2019 as gains can only be deferred until December 31, 2026 no matter which year your investment was made.
- Zero Tax on New Capital Gains
If the investor holds its’ interest in the QOF for 10 years there is no resulting tax on new gains derived inside of the QOF because the taxpayer receives a basis step up equal to the fair market value when sold. For example, suppose you had a $1,000,000 long term capital gain on the sale of Amazon stock in 2018 and elected to defer that gain until December 31, 2026 by investing all $1 Million into the XYZ Qualified Opportunity Fund in 2018. Further, suppose your original $1 million investment into the XYZ Qualified Opportunity Fund grew to $3.5 Million by December 31, 2028 at which time you disposed of your investment in the XYZ Qualified Opportunity Fund for $3.5 Million. Your additional $2.5 Million of gain ($3.5 Million – $1 Million) derived from the increase in value in the XYZ Qualified Opportunity Fund is tax free due to a 100% basis step up in that amount. Please note, on December 31, 2026 the original deferred gain would have been triggered resulting in your paying tax on $850,000 of your original $1 Million of deferred gain (15% basis step up for holding in the QOF 7 years).
How Can Frazier & Deeter Help?
Involve Frazier & Deeter early in either your decision to create a Qualified Opportunity Fund or in your decision to defer gains by investing in a Qualified Opportunity Fund. The IRS is still in the process of issuing Regulations regarding this new area of tax law. We have contacts throughout the industry, including contacts with different Opportunity Funds, and attorneys who can help create and structure these funds. As CPAs, we are simply facilitators and advisors and are not influenced by any sort of commission. If you have questions regarding Qualified Opportunity Fund creation or investment or both or need help with any other tax planning strategies or tools feel free to give me a call at 404.573.4336 or email me at Andrew.Moore@FrazierDeeter.com.