Introducing the Opportunity Zone
Is this a tangible tax incentive or political fiction?
The Tax Cuts and Jobs Act passed in December of 2017 included a covert tax benefit, namely, the Qualified Opportunity Zone (“QOZ”). The QOZ was enacted to incentivize new investment into low income communities. The QOZ was not highly publicized because at the time it was enacted there were no geographical areas designated for the special tax treatment. The zones were to be established by each state no later than April 20, 2018. As recent as July 9, 2018, the IRS has published and approved zones that were nominated by each state. They also have published an interactive map showing specific zone borders corresponding to Opportunity Zone census tracts. In California, there are 879 zones representing 25% of the total possible tracts that meet the low-income threshold requirements. A census tract must have a poverty rate of at least 20% of the area median family income and no more than 80% of the statewide or metropolitan area median income. Census tracts are designed to capture geographic areas of no less than 4,000 people. California’s submission was sensitive to geographic diversity and areas with at least 30 existing business to avoid strictly residential areas. In Southern California, there are numerous designated areas throughout Los Angeles, Long Beach, Santa Ana, Costa Mesa, Huntington Beach, San Clemente, etc.
The federal income tax benefits for qualified investing within an Opportunity Zone can be as follows:
- Defer any capital gain recognition until 2026 by investing within 180 days of the sale or exchange event.
- Benefit from the investment’s operational loss and accelerated depreciation write-offs.
- Step up in tax basis to fair market value after a ten-year holding period.
Capital Gain Deferral Mechanics
The Opportunity Zone investor can defer otherwise taxable capital gains by investing any amount of their capital gain into a corporation or partnership that is a Qualified Opportunity Fund (“QOF”) owning qualified business property. The capital gain deferral is only available if the qualified investment is made within 180 days of the capital gain event. This is similar to the 1031 exchange deadline except there is no intermediary or identification requirement. An investor with a capital gain merely invests cash into a QOF equal to any portion of their capital gain within 180 days of their capital gain event. A tax return election is required by the investor to designate the capital gain deferral and QOF investment.
The capital gain deferral is not permanent. Any elected deferral must be recognized in the taxable year ending December 31, 2026 if the investment is not liquidated sooner. However, the amount of capital gain that is to be recognized is decreased by 10% if the QOZ investment is held for five years and another 5% if held for 7 years if prior to 2026. This 10% and 5% gain exclusion occurs by virtue of a permanent tax basis increase to the investor. The capital gain recognition could be 85% of the original gain deferral to be recognized in 2026 or less if the fair market value of the QOF investment declines from the original acquisition date.
Permanent Exclusion for Tax Basis Increased to Fair Market Value
The bigger tax benefit available to capital gain investors is a full tax basis step up to fair market value if the qualified investment is held for 10 years. After the 10-year hold period, the investor can elect to increase the tax basis of his capital gain investment to fair market value on the date the investment is sold or exchanged. This is a permanent exclusion of the gain achieved from the investment itself. Where the investor holds a syndicated partnership interest, it is apparent the tax basis increase will be an outside basis adjustment to the capital gain investor’s QOF partnership interest. The extent to which the capital gain investor’s tax basis adjustment may be allocable to depreciable property held by a QOF partnership is not addressed within the statute. However, it is clear the disposition of the partnership investment or liquidation of the partnership will allow the basis increase as an offsetting deduction.
Qualified Investment Parameters
The rules are specific to investment into new property acquired after December 31, 2017 which is originally placed in service by a qualified opportunity zone business. For clarity, purchase of used property not originally placed in service by the qualified opportunity zone business will not qualify for the tax benefit. The mere purchase of a preexisting real estate building from another user will not represent qualifying property. In the real estate context, these special benefits will only be available for investment into new construction or a rehabilitation project. A rehabilitation project can qualify if the rehab costs will exceed the adjusted tax basis of the property by the end of a 30-month period beginning on the date the property is acquired (e.g. the rehab cost must be more than the adjusted tax basis of the property from original acquisition). The original property to be rehabilitated must be acquired after December 31, 2017.
The QOF partnership must hold at least 90% of its assets in qualifying tangible property. Intangible property does not qualify. Seemingly, financial assets are not specified as qualifying for the 90% test either. Thus, initial capital raised should be deployed into tangible property and the business entity should not hold other financial assets that would fail the 90% test. We would like to see further guidance to allow for up to one year to deploy the capital raise which is the rule with REIT qualification standards. Failure to maintain the 90% asset composition test, can result in a tax penalty computed as an interest equivalent charge on the portion of assets that fall below the 90% threshold. This penalty does not require acceleration of the capital gain deferral prior to 2026 rather it is like an interest charge on a portion of the deferred gain. Whether the 90% test is measured from fair market values or adjusted tax basis is not clarified by the statute as written.
Discussion of income tax basis disparity and impact on after tax investment underwriting
The investor will have no tax basis pertaining to the portion of the investment representing a capital gain deferral unless the 10% and 5% tax basis increase is achieved. This will create an inside verse outside tax basis difference between investor deferring capital gain and a QOF partnership. The QOF partnership will have full basis for the cash investment from the investor while the investor has no tax basis for the capital gain invested during the deferral period for his QOZ partnership interest. In the year 2026, when the gain deferral ends, the investor’s tax basis will be increased by the gain recognition.
With proper forecasting, due diligence and forward planning, the tax basis disparity can be inconsequential. However, the QOF investor deferring capital gain, could encounter loss suspension technicalities without proper business planning. This can occur from tax basis limitations. The capital gain investor can only deduct losses to the extent of the investor’s tax basis. The investor will be allowed tax basis in his QOF partnership interest from a share of allocable debt from the QOF partnership. For real estate partnerships using a normal capital stack, we expect the capital gain investors will not encounter loss suspension because they are afforded tax basis from traditional qualified nonrecourse debt originated at the project level and allocated to the investors.
In contrast, any losses that could be suspended at the investor level due to inadequate tax basis are not permanently foregone. The investor must recognize the capital gain deferral into income in 2026 which will increase his tax basis in the QOZ partnership interest. Accordingly, any loss allocations exceeding the investor’s tax basis in his partnership interest are suspended for offset against future income allocations from the partnership or freed up by subsequent tax basis increases. Also, during the capital gain deferral period, any cash distributions in excess of the investor’s tax basis in his partnership interest will represent capital gains to that extent. Again, traditional nonrecourse debt financing by a partnership will normally provide tax basis to mitigate these issues. The syndicator should embark to plan and project income tax attributes for disclosure to capital gain investors.
Once losses are available for reporting by the capital gain investor they will be subjected to the passive loss rules. Passive activity losses can only be utilized for offset against other forms of passive activity income. For investors with other passive income sources there will be no passive loss suspension.
Other Noteworthy Facts
Tax benefits associated with a QOZ investment are only available to the capital gain deferral investment. Other cash investors not making a capital gain deferral election are not afforded the tax deferral and tax basis increases pursuant to the QOZ rules. This law would seemingly appeal to both political parties so future law changes are improbable.
In a recent publication, the IRS announced they will allow partnerships and corporations to self-certify their status as a Qualified Opportunity Fund on a form that will be published in the future.
The rules are intricate especially when overlaying these rules to the existing tax law changes. Syndicators would be wise to seek counsel and prepare after tax analysis to entice investors.
Since the tax benefits are only available to investors that defer capital gains, the basis increase to fair market value will not be available to 1031 exchange buyers.
Scott Skinner, CPA
SKINNER FOUCH & OLSON LLP