By Michael McKeown, CFA, CPA - Chief Investment Officer
Looking for tax savings?
With support from communities, developers, investors, and somehow… both political parties?
Meet the qualified opportunity zone (QOZ). The benefit passed in December 2017 with the Tax Cuts and Jobs Act. Due to the tax overhaul including lower income tax rates, this part of the bill largely flew under the radar.
Anyone with a capital gain is eligible to participate. The capital gain can come from any type of property including public stocks, mutual funds, private businesses, or real estate.
Qualified opportunity funds (QOF), businesses operating specifically in QOZs, that accept third-party investors may be subject to accredited investor rules, meaning there are minimum requirements for net worth ($1 million) or income ($300K married, $200K individual). However, there are mass marketed products that do not have such requirements.
There are eligible opportunity zones in all 50 states. In early 2018, states nominated up to 25% of the low-income census tracts within the state. The IRS released a bulletin certifying the full list of QOZs, which can be found on this interactive map.
A QOF is an entity that either invests in tangible property (typically real estate or a development project) within a QOZ directly or invests indirectly through an equity interest in a subsidiary. For a QOF to qualify under IRS rules, effectively all of the property has to be within a designated opportunity zone. Alternatively, a QOF can own an interest in a corporation or partnership, and the investment will qualify if the underlying entity derives 50% or more of its gross income from an active business in a QOZ. The business also cannot be a “sin business,” such as a liquor store, casino, etc.
The QOZ property must be acquired after December 31, 2017. If an existing property, the fund must substantially improve the property by at least the purchase price (the initial basis) within 30 months following the acquisition. The “property” does not have to be real estate necessarily and could be a business interest.
Treatment of capital gains and deferrals
An investor can reinvest the capital gains on a property sale to defer and/or reduce those capital gains taxes. The first step is to identity a QOZ fund to invest in within 180 days of the sale of the property. The initial tax basis in the qualifying investment is zero. After the investment is held for five years, the tax basis in the original investment is increased by 10% of the deferred gain. After the investment is held for seven years, the tax basis increases an additional 5% to a total of 15%. Investors must recognize gain by the earlier of when the QOF is sold or December 31, 2026, on the original 85% of capital gains. After ten years, investors permanently avoid any capital gains tax on the post-acquisition gains as it steps up to fair market value. There is no limit on the amount of gain that can be used.
Let’s use an example. Jane bought Apple stock for $200,000 and it appreciated to $300,000. To defer paying taxes on the $100,000 in capital gains, she invests $100,000 from the sale into a QOZ fund four months later. Jane forecasts 10% annual appreciation in the QOZ fund. Jane keeps the $200,000 from the original basis and has no restriction on these funds. After five years, the basis of the deferred gain goes from $0 to $10,000 (10% step-up). After seven years, the basis steps up an additional 5% to a total of $15,000. By December 31, 2026, she would owe capital gains tax on the $85,000 from the original sale.
After 10 years pass, Jane can elect to increase the basis of the QOF to its fair market value on the date of sale. This saves paying taxes on the $185,000 gain. With the stepped up $15,000 in basis and not paying taxes on gains on the QOF, this saves her $40,000 in capital gains tax!
The $100,000 investment increased to a total value of $285,000. She only owes capital gains taxes on $85,000 and it is deferred for eight years!
Get off the narrative. We humans like stories and anyone raising money for a project has one. These can mesmerize prospective investors so much that they forget to focus on the “how.” How can this be successful? How can this go wrong? How many similar projects has the developer/manager completed? How is the manager compensated and are the fees reasonable?
Show me, don’t tell me. Verify historical track record with third party reports. Perform background checks. This is the time to leave no stone unturned.
There are trillion of dollars of capital gains eligible to participate. Deferring capital gains with potentially minimal taxes owed is a game changer. This is truly something new that creates wins for communities, developers, and investors. Nonetheless, investors must be vigilant considering the risks of any QOF and how it fits into the construction of an investment portfolio.
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