Qualified Opportunity Zones Tax Benefits for Real Estate

A lot of the ink spilled in the aftermath of 2017’s Tax Cuts and Jobs Act (“TCJA”) focused on the corporate tax rate reduction to 21% or the introduction of the 20% 199A deduction for passthrough entities. However, one major tax incentive has often been overlooked: Qualified Opportunity Zones (“QOZs”). Investments in QOZs present a powerful tax-saving opportunity for investors.

Under the TCJA, a new tax incentive program was introduced to the tax code in Section 1400Z to foster economic investment in distressed communities. The tax incentive centers on investments in QOZs, which are low-income census tracks nominated by States and then reviewed, certified, and designated by the Department of Treasury. Tennessee currently has 176 certified QOZs throughout the state.

Clarity for Qualified Opportunity Zone Fund Investing

Qualified Opportunity Zone Funds were a creation of the Tax Cuts and Jobs Act passed in December of 2017 and offer investors significant tax savings opportunities.
Investors can defer paying tax on currently taxable capital gains and eliminate portions of their deferred gains over a 5-7 year holding period.
The appreciation of Opportunity Fund investments can be tax free if sold following a 10-year holding period.
Final Regulations issued in December provide investor-friendly provisions around the types of capital gains that can be deferred and the timeline for investment.

One of the provisions of the 2017 Tax Cuts and Jobs Act included the Investing in Opportunity Act, which created a unique investment option that would allow investors to defer capital gains and help to revitalize low-income areas. The IRS first provided proposed guidance on this Act in October of 2018, and it was a step in the right direction. Another round of proposed regulations was released in April of 2019. While these regulations have been helpful in understanding how this new law would be applied, the guidance was somewhat vague and left many unanswered questions for potential investors, while also creating some new concerns. However, in December, the Treasury Department released final regulations, giving much needed clarity to the Opportunity Zone rules with hopes that investors will now be more willing to make the leap into a Qualified Opportunity Fund.

What are Qualified Opportunity Zones (QO Zones)?

A Qualified Opportunity Zone (QOZ) is an economically-distressed community or low-income communities where new investments, under certain conditions, may be eligible for preferential tax treatment. QO Zones are economically-distressed communities designated by each state.

Governors were allowed to designate 25 percent of their states’ eligible census tracts as QO Zones based on economic need and desired paths of growth. Nearly 12% of the United States has been designated as a QOZ. There are 176 census tracts in Tennessee that have been selected as QOZs based on the determined criteria, and they will retain their QOZ status for 10 years. The intent is to incentivize investors to defer, and potentially eliminate, a portion of their capital gains depending on the length of their investment, while at the same time revitalizing economically distressed areas around the country.

Certain designated localities qualify
These localities must be nominated by their state
The state nominations must be certified by the secretary of the U.S. Treasury

What’s an Opportunity Zone's purpose?

Opportunity Zone’s were added by the recently passed Tax Cuts and Jobs Act on Dec. 22, 2017, to spur economic development.

Opportunity Zone’s are new! No relation to prior economic incentives.
They are designed to encourage long-term investments in low income urban and rural communities nationwide.
Opportunity Zone’s motivate economic development by providing tax benefits and incentives to investors.

How Does the Investment Work?

After selling an investment and incurring a capital gain, an investor has a 180-day period to reinvest funds into a Qualified Opportunity Fund (QOF). A capital gain that would otherwise be taxable outside of the QOF investment is the key entry point to the tax incentives offered by the Opportunity Zone rules. Without a capital gain to defer, the tax incentives are not available.

A QOF is an investment vehicle that can either be organized as a partnership or a corporation with the purpose of investing in a QOZ. At least 90% of the QOF’s assets must consist of QOZ property, which can be stock or a partnership interest in a business located in a QOZ, or QOZ business property. QOZ property must either be original use to the QOF or substantially improved by the QOF. There are numerous rules and guidelines around how a QOF is structured, what assets it owns, and what assets it cannot own. For the purpose of this article, we focus on the rules for an investor in a QOF meeting all the relevant criteria.

What are the tax benefits of an Opportunity Zone?

Through an investment vehicle known as an Opportunity Fund, Opportunity Zone’s provide for both temporary and permanent tax deferral for eligible investors.

Investment in an Opportunity Fund provides temporary deferral from other investments without immediately triggering recognition of those gains. The deferred gain must be recognized on the earlier of the date on which the EO investment is sold or Dec. 31, 2026.
Opportunity Zone’s provide permanent deferral on capital gains if the opportunity fund is held for at least 10 years. The exclusion only applies to gains accrued AFTER an investor makes his/her investment in an Opportunity Fund.
A qualified Opportunity Fund is a privately managed investment vehicle created as either a partnership or corporation for the purpose of investing in qualified opportunity zone property.

What incentive does the Opportunity Act provide?

Realized capital gains (short-term or long-term) can be reinvested within 180 days into QO Zones through qualified opportunity funds (QO Funds). Tax on the reinvested gain can be deferred up until Dec. 31, 2026. (If it’s sold earlier, tax is recognized, or it can be rolled into another opportunity fund and remain tax-free.) In addition to deferring gains, taxpayers can reduce their recognized gain by 10 percent after holding the asset for five years, and by an additional 5 percent after holding it for seven years, ultimately only paying tax on 85 percent of the recognized gain. That’s 15 percent of the original gain permanently excluded from income inclusion.

That’s not all! The biggest benefit comes at the 10-year mark. At that point and into the future, the investor will be exempt from any gain/appreciation that accrued after the original re-investment. The QOZ investment grows tax-free, like a Roth IRA, provided it’s held for at least 10 years.

A key component and the new financial product for this incentive is the qualified opportunity fund (QO Fund). A QO Fund is any investment vehicle organized as a corporation or partnership (including an LLC treated as a partnership for tax purposes) investing in QO Zones. The fund can self-certify and must hold at least 90 percent of its assets in QOZ property. QOZ property consists of QOF stock, QOF partnership interest, or QOZ business property.

Initially, there was very little guidance on how to properly take advantage of the benefits created by the Opportunity Act. As discussions about this monumental opportunity circulated, there were many questions and issues raised by professionals and taxpayers alike. Proposed regulations have recently been issued to address some of these questions.

Why Should You Invest in a Qualified Opportunity Fund?

There are three tax incentives for someone that invests in a QOF:

Deferral of tax on otherwise taxable capital gains
Step up in tax basis on the deferred gain
Permanent exclusion of taxable gain on investment appreciation

The first incentive, a deferral of tax, allows for an investor to temporarily defer the gain that would have been recognized in the current period by reinvesting into a QOF. The original gain will be deferred until the investment is sold or December 31, 2026, whichever occurs first.

The second tax incentive is an elimination of a portion of the deferred gain if certain holding periods are met before the 12/31/2026 deadline. An investor holding their QOF investment for five years receives a 10% basis step-up (or taxable gain elimination). At a holding period of seven years, another 5% basis step-up is available, creating a maximum possible gain elimination of 15%. To reiterate, the holding period of the QOF investment must meet these timeline requirements prior to 12/31/2026 in order to qualify for these basis step-ups.

A third, and potentially largest, tax incentive is the complete elimination on all capital gain on appreciation if the asset is sold following a 10-year holding period.

There are two important distinctions to be made regarding these tax incentives:

Unlike a 1031 exchange where the actual funds from a capital sale must be held by an intermediary and reinvested in order to qualify for favorable tax treatment, there is no tracking of actual dollars to be invested in a QOF. Any capital gain can be deferred as long as dollars are invested in a QOF within the 180-day reinvestment period.
An investor in a QOF will pay tax on the deferred gain. While they may qualify for basis step-ups during the deferral period, every taxpayer investing in a QOF will pay tax on at least 85% of their deferred gain by 12/31/2026. Assuming the QOF investment is held 10 years or more, the 12/31/2026 tax payment on the deferred gain will be the last applicable tax on the QOF investment, no matter how much it appreciates.

Real Estate Investors have an opportunity for temporary and permanent tax deferral

Opportunity Zone’s provide a very tax efficient vehicle for those investors looking to reinvest their current unrealized gains in economically distressed communities and thus escape tax through temporary and/or permanent deferral.

Temporary Deferral of Capital Gains

Investors can invest capital gains from other investments into Qualified Opportunity Funds (QO Funds) without immediately triggering recognition of those gains. This deferral of capital gains works similarly to a 1031 exchange in real property, except the investor can elect to invest solely the capital gains from other investments and the gains can come from any investment, including stocks and bonds, not just from real property.

An investor can the defer capital gains on the amount of gains invested in the QO Fund until such time that the investment is sold or exchanged, or December 31, 2026, whichever is sooner. The investor would have a tax recognition event on December 31, 2026, even if the investor still holds the investment.

A QO Fund is a self-certified partnership or corporation that holds at least 90% of its assets in eligible QOZ property. Setting up a QO Fund does not require IRS certification and only requires a simple form be attached to the entity’s federal income tax return.

Free Basis Step-Up

If an investor holds the QO Fund investment for at least 5 years, then the investor receives a 10% basis step-up on the amount of the deferred capital gain invested. If the investor holds the investment for at least 7 years, then the investor receives an additional 5% basis step-up on the amount of the deferred capital gain (for a maximum total of 15%).

Gains on QOZ Investment can be Tax-Free

The final piece of good news is that any gains on the investment in the QO Fund are tax-free if the investment is held for at least 10 years. After 10 years, investors can elect to make their basis in the investment equal to the fair market value of the investment on the date of sale.

Example

On July 1, 2018, Investor A sold stocks totaling $2 million with tax basis of $1 million for capital gains of $1 million.

Within 180 days of the stock stale, Investor A decides to invest the $1 million in capital gains into a QO Fund. Investor A has no immediate taxable gain from the sale of stock and now has $1 million investment in the QO Fund.

After holding the investment for 10 years, Investor A’s investment is worth $2 million. On July 2, 2028, Investor A sells the investment for $2 million and makes the fair market value basis adjustment election.

Here are the tax consequences:

As of December 31, 2026, the investment was held at least 5 years, so Investor A received a 10% basis adjustment on the amount of the invested capital gains.
As of December 31, 2026, the investment was held at least 7 years, so Investor A received an additional 5% basis adjustment on the amount of the invested capital gains.
Investor A recognized $850,000 in capital gains on December 31, 2026 ($1,000,000 in capital gains invested in Qualified Opportunity Fund minus 15% basis adjustment of $150,000).
On July 2, 2028, Investor A does not recognize any additional gain on the QO Fund investment even though the value of his investment has increased by $1 million. ($2 million sale minus $2 million in tax basis).

Understanding tax reform and how the changes will affect your business and you as an individual can be challenging with opportunities left on the table. Be sure you consult with a tax advisor who has deep expertise in the multifaceted law and all its nuances.

Highlights of the QOF Investments and Final Regulations

There are several key distinctions that were made in the final regulations that are important to QOF investors:

How is the 180-day Reinvestment Period Impacted by Capital Gains from a Flow-through Entity?

In order to qualify, a capital gain must be reinvested in a QOF within 180 days. For an individual selling a share of publicly traded stock, the start of that 180-day window is easy to determine. It begins on the date the sale occurs and the capital gain is incurred.

But what if an investor incurs a capital gain through a partnership investment? In some cases, the investor may not be aware of the capital gain that will be taxed to them until their receive their K-1, likely long after the event creating the capital gain took place. This was considered by the IRS, and relief was provided in the final regulations. An investor who is deferring capital gain from a flow-through entity has 180 days from any of the following:

The date the flow-through entity incurred the gain,
The final day of the flow-through entity’s tax year (December 31 for a calendar year entity), or
The original due date of the flow-through entity’s tax return, not including extensions.

Based on these rules, the maximum amount of time a taxpayer has to reinvest capital gains reported to them by a partnership would be 180 days from March 15 (partnership tax return due date) or September 11.

Are Section 1231 Gains Eligible for Investment, and When?

The regulations are clear that capital gains arising from ANY source (that is not a related party) are eligible for the tax incentives when invested within the prescribed timeline. That includes Section 1231 gains, which arise from the sale of business assets, such as rental real estate, and are treated as capital gains.

The previously proposed regulations created much concern about the deferral of Section 1231 gains and the timing of investment. Because gains from Section 1231 assets must be netted against losses incurred from similar transactions to determine their ultimate taxability, the proposed regulations dictated that investors were required to wait until December 31 each year before their gains from 1231 assets were eligible for reinvestment, after they had been netted against other losses. Fortunately for investors, the final regulations removed the delay. Gross 1231 gains are eligible for deferral when incurred, and there is no requirement to wait until the end of the year to invest. This gives investors a bigger time window and the potential for more gain to invest and tax to defer.

Are Capital Gains Related to Installment Sales Eligible?

One limitation on capital gains that are eligible for deferral under the QOF rules is that they are incurred by the taxpayer after December 31, 2017. One question left unanswered by the two previous rounds of proposed regulations was how that rule applied to installment payments received after 12/31/17, but that originated from installment agreements entered into prior to that date. The final regulations offered another taxpayer-friendly answer. Under the QOF rules, each installment payment carries with it eligible gain, and the option of its own 180-day investment window. So even if the initial sale giving rise to the installment agreement originated before 2018, each payment received is considered a new occurrence of capital gain which can be eligible for deferral. Investors also have the option of two choices when it comes to the eligible investment period for installment sale gain: the 180-day window for investment can begin on the date of each installment payment during the year, or investors can opt to use December 31 of the tax year to begin the 180-day window for all the installment payments received during the year. This gives the investor options with which to maximize their investment and tax deferral.

As with nearly all areas of tax law, there are many nuances and complications to be aware of when considering an investment into a Qualified Opportunity Fund. While there are significant tax incentives available, planning with tax and investment advisors will help ensure the benefits are maximized without creating unintended consequences.

Content provided by LBMC tax professionals, Jeff Talley, Blake Harrison and Gia Trevino.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.

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Opportunity Zone

IRS Updates

12/19/19 – The Internal Revenue Service issued final regulations (PDF) providing details about investment in qualified opportunity zones (QOZ). The final regulations modified and finalized the proposed regulations (PDF) that were issued on October 28, 2018 and May 1, 2019. [IR-2019-212]
4/25/19 – The IRS has issued guidance about investing in qualified opportunity zones (QOZs). It clarifies the “substantially all” requirements for the tangible business property’s holding period and use in three ways: 1) At least 70% of the property must be used in a QOZ; 2) for the holding period, tangible property must be QOZ business property for at least 90% of the qualified opportunity fund’s or QOZ business’s holding period; and 3) the partnership or corporation must be a QOZ business for at least 90% of the fund’s holding period. [REG-120186-18]
The Opportunity Zone tax incentive benefits were passed as part of the TCJA. The IRS has designated 8,761 communities as Opportunity Zones. Investors that make appropriate investments in the zones can defer tax on almost any capital gain, through 12/31/26. An investor must have made an election after 12/31/17 and meet other requirements.
In October 2018, the IRS and Treasury Department issued proposed guidance (IR-2018-206) for the new Opportunity Zone tax incentive. The proposed regulations clarify that almost all capital gains qualify for deferral. In addition to the proposed regulations, they issued an additional piece of guidance to aid taxpayers in participating in the qualified Opportunity Zone incentive. Rev. Rul. 2018-29 provides guidance for taxpayers on the “original use” requirement for land purchased after 2017 in qualified opportunity zones.
The IRS has added Opportunity Zone frequently asked questions (FAQs) to its website explaining the tax benefits of Opportunity Zones and how to qualify for Qualified Opportunity Fund status.