A provision of the Tax Cuts and Jobs Act (TCJA) of 2018 allows investors to defer taxes on capital gains by investing them in properties and businesses in Qualified Opportunity Zones (QOZs). The purpose is to encourage investment that will revitalize low-income areas. Essentially QOZs allow investors to take capital assets that have appreciated, monetize them, and defer the gain for up to seven years, or through 2026.
A typical investor might be a client selling a stock that has amassed substantial capital gains over time. A QOZ unties the binds that keep that individual from selling by allowing him or her to re-invest the gains tax-deferred in a Qualified Opportunity Fund (QOF).
Qualified Opportunity Zones are designated by state governors and currently all 50 states have designated zones in their respective jurisdictions. Florida's governor Rick Scott added its name to that list as of April 19, 2018 with his recommendations for zones in 427 communities across every county in the sunshine state. As in the case of TCJA, and most new tax legislation, subsequent regulations will be required to address some unresolved issues, but all QOFs do provide federal capital gains tax benefits. Here's how it works:
If a client sells an investment that generates a capital gain before December 31, 2026, and re-invests the gain in a QOF within 180 days, the benefits are:
- Deferred taxes on the initial gain until December 31, 2026
- Elimination after five years of a portion of the deferred gain
- Elimination of more of the gain after 7 years
- Elimination of post-rollover appreciation after 10 years
The following guidelines must be considered for qualified, preferential tax treatment under a QOF:
- To qualify as a QOF, the corporation or partnership must have 90 percent of its assets invested in QOZ properties or businesses.
- A QOF investor can be any taxpaying entity: individual, partnership, S corporation, trust.
- An "unrelated person" is an entity in which the investor does not have an ownership stake of more than 20 percent. The rule would keep the investor from selling the original investment to himself, or an entity in which the investor holds a substantial stake, such as in a current partnership, for example.
- The provision applies only to capital gains, including 1231 and 1250 gains, but not gains taxed as ordinary income.
To achieve deferral or potentially eliminate the tax on a QOF investment, the investor must commit the capital gain to an investment in a QOF within 180 days of the sale of the original investment. Then:
- After five years of holding the investment in the QOF, the basis is increased by 10 percent of the initial deferred gain, thereby permanently excluding from income that 10 percent.
- After 7 years, the basis in the investment is increased by another 5 percent of the deferred gain, thereby permanently excluding that amount from taxable income.
- After 10 years of holding the QOF investment, the investor can elect to have the basis equal its fair market value when the investment is sold. Because the originally deferred gain will be taxed December 31, 2026, with a corresponding adjustment in basis, the rule has the effect of excluding from tax all post-rollover appreciation.
Even if an investment is not made in time to capitalize on the seven or five-year basis-point increases, there are still advantages to investing in a QOF. Invested capital gains are still eligible for deferral until December 31, 2026. As well, the investor remains eligible for the 10-year rule allowing all post-rollover appreciation to be permanently excluded from being taxed.
One of the requirements for qualification as a QOZ business is that less than 5 percent of the average of the aggregate unadjusted bases of property held by the entity must be attributable to nonqualified financial property (NQFP). Under Section 1397C(e), the definition of NQFP does not include reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less. If documented adequately, capital can be used for expenses, effectively maintaining the investment as a QOF at less than the prescribed 90 percent threshold.
Another round of regulations from the Treasury Department for QOFs is expected by the end of the year. Among the issues that need to be addressed is the requirement that at least half of all receipts from a QOZ business come from their zone of location. That might make sense for a single grocery store or apartment building, but not necessarily for a manufacturer selling its products throughout the country. The sales might be dispersed but the income, jobs and other benefits are clearly local.
Other questions hoping to be answered by the next round of regulations include:
- What are the federal tax benefits relative to the income generated from this investment?
- The QOFs will likely own a portfolio of businesses in the zone, but what are the benefits to the operating entities?
We will closely monitor future announcements from the U.S. Treasury Department on this topic and provide updates as soon as they are available.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.