Does your portfolio have gains that you would prefer to lock in, but you don’t want to pay capital gains taxes? Are you considering the sale of a business, real estate, or any other appreciated asset over the next few years? Or have you already realized a large number of capital gains in the past few months?
If the answer to any of those questions is “yes,” you need to know about Qualified Opportunity Zones (QOZs). A QOZ is a community investment tool established by Congress in the 2017 Tax Cuts and Jobs Act to encourage long-term investments in underserved communities.
It provides a tax incentive for investors to reinvest their unrealized capital gains into dedicated Opportunity Funds.
What is an Opportunity Zone?
An Opportunity Zone is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. An investment in a QOZ (or a Qualified Opportunity Fund) can allow you to defer and reduce taxes on your capital gains, while benefiting low-income communities across the US. Gains on your QOZ investment will ultimately be tax-free if they meet the holding period requirement.
How do you invest?
A Qualified Opportunity Fund (QOF) can be created with the specific purpose of investing in Qualified Opportunity Zones. QOFs must follow certain rules to comply with IRS regulations.
What are the tax benefits? QOZs offer potential tax benefits to investors in three ways:
TAX DEFERRAL –Investors may defer capital gains resulting from the sale of any type of property (e.g., real estate, stock, art, bitcoin, etc.). Only the gain amount needs to be reinvested in order to defer the taxes, and reinvestment must occur within 180 days of the sale. The original gain (subject to reductions described below) must be recognized in the 2026 tax year. If the Opportunity Zone investment is sold before 2026, the original gain will be recognized in the year of the sale.
GAIN REDUCTION – Investors who hold a QOZ investment for five years will have their original gain reduced by 10%. Investors who hold the investment for seven years will receive an additional 5% reduction in the original gain for a total gain reduction of 15%.
SPECIAL GAIN EXCLUSION – Gains on the QOZ investment will be tax-free if the investment is held for 10 years.
NEW PROPOSED REGULATIONS
In April 2019, additional regulations were proposed. The following outline summarizes certain key provisions of the second set of proposed regulations. It is not meant to be comprehensive and is subject to change.
QOFs are permitted to refinance debt and make interim cash distributions after two years.
The ability to refinance debt and distribute cash helps alleviate concerns about paying the tax liability on the original gain in 2026 and concerns about the 10-year holding period. Investors are expected to benefit from favor-able tax treatment of depreciation. Depreciation is treated as a deduction against the income of a property and reduces a real estate investor’s cost basis. When a property is sold for a gain, the accumulated depreciation is often treated as taxable income—this is called depreciation recapture. Under the proposed regulations, it is expected that both capital gain and depreciation recapture will be eliminated after the property is held for 10 years. An investor can receive the benefits of depreciation in reducing taxes on cash distributions without having to worry about depreciation recapture upon a sale. This could have a significant impact on after-tax returns.
QOFs will have more time to invest their cash contributions.
QOFs must periodically pass asset tests to confirm that Opportunity Zone property comprises at least 90% of the fund’s assets. This had created concern that cash contributed shortly before the date of an asset test could cause a fund to fail to achieve the 90% threshold. The proposed regulations exclude cash contributed during the six months before the asset test dates, easing concerns that investments will be hurried simply to avoid penalties. Partnership tax rules will apply to QOFs. Part-nership rules will apply to QOFs, meaning that gains and income will pass directly to the individu-al investor in the QOF. This can benefit QOFs that are structured as partnerships rather than real estate investment trusts (REITs).
A QOF may sell individual properties and receive favorable tax treatment any time after the 10-year holding period.
The IRS proposed a clarification that permits the manager of a QOF to divest assets in a straightforward, orderly fashion. There was previously concern that a QOF might be required to dispose of all its assets within the same year to receive favorable tax treatment. This highly anticipated clarification provides flexibility to dispose of assets to the right buyers at the right time instead of wholesale or in a manner requiring complex structuring.
A QOF may sell properties before the 10-year holding period.
If a QOF divests a property before the 10-year holding period expires, there will be no adverse tax consequences if the proceeds are reinvested in another Opportunity Zone property within a twelve-month period.
The tax benefits of a QOF will transfer to heirs.
Upon the passing of a QOF investor, his or her heirs will receive the same tax benefits that the original investor would have received.
Any future changes to the Opportunity Zone statutes and guidance cannot be applied ret-roactively.
Although changes to the tax treatment of a QOF cannot be applied retroactively, tax rates can change and can either positively or negatively affect investors.
Triple-net leases are disallowed.
These types of properties are considered “passive” and are not eligible investments for a QOF.